Have you ever seen the transformation of an old, rusted-out car be restored to its original glory? It takes vision, money, and a great deal of expertise and hard work. It takes a special eye to see the potential in something that most would brush off as a piece of junk.
When done right, a few years later, you sell the car for a profit, to someone else who values it as much, if not more than you do.
You took something that had been overlooked, committed some sweat equity, and breathed new life into it. This is the essence of value-add, and it’s a commonly used strategy in real estate investing.
How Value-Add Real Estate Works
Most people are familiar with how the strategy of a fix-and-flip works. With a fix-and-flip, a single-family, run-down property is purchased. The asset is then remodeled and sold at a profit. In the case of a fix-and-flip, your sweat equity and ability to see a diamond in the rough is monetarily rewarded. The new owner also benefits, by getting to enjoy an updated, move-in ready home.
Using value-add in multifamily real estate deals follows a similar model but on a much larger scale. With a multifamily property, hundreds of units get renovated over years at a time instead of just one single-family home being remodeled over a few months.
A great value-add property for instance may be lacking in curb appeal and may negatively impact the initial impression that a potential renter may form. By making simple, cosmetic improvements, like upgrading peeling paint, outdated appliances, or overgrown landscaping, the property will start attracting more qualified renters and the income the property produces will increase as a result.
The purpose of making improvements In value-add properties is to first, improve the unit and the community, which positively impacts tenants, and second, to increase the bottom line, which positively impacts the investors.
Examples of Common Value-Add
Value-add renovations commonly seen in individual unit upgrades can include improvements such as:
- Fresh interior paint
- New cabinets
- New countertops
- New, upgraded appliances
- New flooring throughout the unit
- Upgraded fixtures
By adding value to exteriors and shared spaces, the property often develops an increased sense of community. Common exterior improvements include:
- Fresh paint on building exteriors
- New property signage
- Improved landscaping
- Dog parks
- Covered parking
- Shared spaces, such as a BBQ pit, or walking trails
Adding value to a property can also take the form of increasing overall efficiency. Here are common examples of how efficiencies can be improved:
- Green initiatives to decrease utility costs
- Shared cable and internet
- Reducing expenses
The Logistical Framework of a Multifamily Value-Add
The basic fix-and-flip of single-family homes is pretty familiar to most people, but when it comes to renovating hundreds of units at once, the logistics take a little more planning. Oftentimes, investors wonder how a property is renovated while people are living there and how many units can be remodeled at a time.
When renovating a multifamily property, the vacant units are addressed first. In a 100-unit complex, a 5% vacancy rate means there are five empty units, which is where renovations will begin.
Once those first five units are complete and as each existing tenant’s lease comes due for renewal, they are offered the opportunity to move into a freshly renovated unit. Typically, tenants jump at the chance to move into an upgraded space and are happy to pay a little extra.
Once tenants vacate their old units, renovations continue until the process has repeated and most or all of the units have been updated.
During this process, some tenants do move away, so the project’s business plan needs to account for a possible temporary increase in vacancy rates due to turnover and new leases.
Investing in Value-Add Properties Benefits Everyone
When done well, value-add strategies benefit the tenants as well as the investors. By renovating the property, the tenants get to enjoy a more aesthetically pleasing property, with updated appliances and more attractive community space. By doing so, the property becomes more valuable, which allows for higher rental rates and increases the equity of the property, which benefits the investors.
The property-beautification process and the fact that renovated property is more attractive to tenants is probably straightforward. But let’s dive into why value-add investing is a great strategy for investors.
What’s a Yield Play?
To fully understand why value-add investments are so powerful, we must first understand their counterparts, yield plays. In a yield play, investors buy a property that’s stabilized and hold it for some time, collecting the monthly cash flow and hoping for potential future profits.
In yield play investments, a property that’s in decent shape and currently cash-flowing- is purchased. The property provides a recurring stream of income from the rents collected or the yield. There’s a hope to sell it for a small profit down the road, but there is no business plan to renovate, force appreciation, or improve the property to realize a larger gain at sale. Yield play investors simply hold the asset in anticipation of potential market increases. The problem with yield plays is there’s always the chance of experiencing a flat or down market instead.
Why Value-Adds are Superior
Value plays and yield plays are different types of investments. In a value-add investment, significant work takes place and the renovations completed greatly increase the value of the property. Doing major improvements, however, carry an increased level of risk.
The potential upside of value-add deals is attractive to investors because they’re in a position to hold the cards. By taking action steps that improve the property and increase its value, value-add investors don’t just hold the asset hoping for market increases, they force increases through renovations that improve the asset, raising rents and lowering expenses.
Commercial properties are valued based on how much income they generate, not on comps, like single-family homes. By improving the property, increasing income, and also increasing the equity in the deal, investors have much more control over a value-add investment than in a yield play.
Of course, a hybrid investment is ideal, meaning a deal that incorporates yield + value-add. This is where property gets renovated, cash-on-cash yields are high and the market increases simultaneously. Investors have control over the value-add renovation portion and the market growth adds appreciation.
While there’s great potential in a hybrid investment, there are also increased risks associated with any value-add deal.
Common Risks in Value-Add Investments
In multifamily value-add investments, here are the common risks:
- Not being able to achieve target rents
- Higher vacancy rate than expected
- Renovations running behind schedule
- Renovation costs exceed initial estimates, which can greatly impact the overall budget of the deal.
How We Mitigate Risk
As an investor evaluating potential deals, be sure to look for sponsors who hold capital preservation in the highest regard. Capital preservation should be at the forefront of the plan with several risk mitigation strategies in place. These may include:
- Conservative underwriting
- Proven business model, with some units already having been upgraded and achieving rent increases
- Experienced team, particularly the project management team
- Multiple exit strategies
- The budget for renovations and capital expenditures is raised upfront, rather than through cash flow
Risk mitigation strategies are important because although value-add investments can be powerful vehicles of wealth, they also come with serious risks. In every deal, investor capital should be protected at all costs.
Is a Value-Add Deal a Good Fit for You?
As you know, no investment is risk-free. In the case of a value-add investment, however, the great benefits to the community and investors can oftentimes overshadow the inherent risks, making these deals quite attractive to potential investors.
Properly leveraging investor capital in a value-add investment allows for significant improvements to be made in apartment communities, which creates a cleaner, safer place to live and increases tenant satisfaction.
In value-add deals, investors have control over how and when renovations are executed and don’t have to rely solely on market appreciation, which gives them more options when it comes to safeguarding capital and maximizing returns.
If you can imagine conducting a fix-and-flip as you would on a single-family home, except at a hundred-unit scale, that’s essentially what value-add real estate syndications are. The good news is, through the 25/8 Investor Club, you have the opportunity to invest alongside us in real estate syndication opportunities we’ve personally vetted and approved as excellent avenues to grow your wealth, expand your free time, and establish your family’s legacy.