What is "Value-Add" Real Estate?
by Christopher Levarek
“Never lower Your Price, Add Value”
- Grant Cordone
Imagine you are at company event or holiday party for your job. The guy next to you, a dirty martini in hand, is discussing some business venture and says, “ Well, obviously, this is a value-add play”.. Nodding in agreement, you look for your significant other, as well as your exit, thinking “What the heck is he talking about… and where are the appetizers?”
Ok, so maybe this hasn’t happened to you but what exactly are value-add plays? Today, we are taking a look at this term “value-add” and how we use it in real estate investments to drive appreciation or increase the value of real estate. At it’s base, value-add simply means taking an object or investment, increasing the value to some degree for the next buyer in order to not only improve the product but gain some profit as well.
So let’s say you find a broken down VW car. Since you enjoy working on cars, you buy it from the junkyard and spend the next 10 months repairing the car to working order. You put a nice coat of paint, a new horn and patch the holes in the seats. When the car is firing on all cylinders and the fresh paint shines in the sun, you sell it to another buyer who pays 3x what you paid for it. You and the buyer both walk away fulfilled having both received something of value.
This is the essence of value-add and how many real estate investments are structured in the market.
Value-Add Real Estate
The strategy of “adding-value” is most easy to see and understand when looking at your home. When it comes to a house, often investors or homeowners will improve the home by adding new bathroom vanities, new coats of paints and put in new tile flooring. When they move onto the next home, the older house now has grown in value due to the upgrades and the new owner has a better house because of it.
When it comes to multifamily real estate or apartments, the concept is very much the same yet simply applied to the hundreds of units or apartments in the property. Each unit is refinished and refurbished over a timeline to improve the living conditions and offer a better product to the tenant. Of course for investors, improving the units increases the revenue from increased rents and thus provides a positive increase in return on investment.
Types of Value-Add
Below are some of the more common value-add renovations applied to apartment units :
New Flooring (ie. vinyl plank flooring, instead of carpet)
New Washer/Dryer
New Kitchen Appliances
New Countertops
Fresh coat of paint
New Bathroom vanity
Upgraded Fixtures
The renovations above are most typical on the interior side but for the property or exterior, additional upgrades include :
Improve Pool appeal
New remote work/casual lounge areas
New Dog Run area
Covered Parking
New Workout/Gym facilities
Fresh Exterior Paint
Upgrade Lighting Fixtures
Landscaping
Improve Shared Spaces (BBQ/Picnic areas)
Value-add can also mean improving the efficiency of units through :
Install water efficient toilets or monitoring systems
Install green efficient lighting
Decrease expenses on utilities through shared programs
etc.
The Renovations Schedule
One typical question we get on multifamily acquisitions is, “How do renovations get completed while people are living there?” In a single family home, most people simply either perform the renovations while living there or sustain the cost of an empty house as they flip the property. This is in fact a very big reason to consider multifamily investments, the benefits of economies of scale and multiple unit flexibility.
In a large multifamily property of 100+ units for example, there will always be some vacancy. People move and people move out, so 5-7% of the property will have empty units at any given time. This percentage is called the vacancy rate and typically where renovations begin. These units get renovated and once completed are leased out to new tenants at new rental rates.
The cycle continues as now five more units empty out due to ending leases or people moving and renovations begin on those now empty units. So it’s a natural emptying of old units and renovating that occurs until all the units have been updated. In some cases, there might be higher or lower vacancy depending on when or how the property was acquired but this is the general renovations schedule that occurs in large multifamily.
Why We Choose Value-Add Every time
Impact Investing
A big part of any project is the end goal or purpose. A major piece to our purpose is impact investing, or making a difference in people’s lives and bringing more to the community then just an improvement to the bottom-line. When a project is value-add, there is a significant improvement to overall living conditions of tenants.
In truth, these renovations would not have been done in most cases by present owners as the cost is typically not something the seller/owner has saved up. This means these properties are often in need of upgrades and the tenants are living in average living conditions with possible repair issues.
By improving the property, not only are we increasing the value keeping our investors happy with the increased rents and equity, we are building an attractive community space and providing the tenants with a much nicer living space.
Better than a Yield Play
It is worth noting, that typical other investments in real estate rely mainly on appreciation to make an investment worthwhile. This means, an investor purchases real estate and waits for the market to increase the value for potential future profits when it is sold to the next seller. This is what is called a “yield play”. The main problem with this scenario is that sometimes the market shifts and there in lies the risk. Everything is dependent on the market.
On the other hand, value-add allows an investor to control the appreciation rather than let the market be the sole dictator of the price. Value-add plays allow something called “forced appreciation”. Like it sounds, this is that concept of forcing appreciation or value to increase of the real estate property. This is done through providing renovations, increasing rental rates and overall value through these upgrades.
The real sweet spot of course is performing value-add within an expanding market. In this case an investor can benefit from both value-add and a yield play. The value of the property increases due to renovations AND the market, thus providing a great amount of combined appreciation benefits and higher returns.
What are the Risks?
Inherently value-add allows for much greater control on the outcome of a business plan however there are risks to a value-add business plan. The following are some of the possible risks:
Target rents not attained
Increased vacancy then expected(more tenants moving out)
Renovations behind schedule
Renovation costs higher than estimates
When working on large multifamily properties, these risks can be important to recognize. Having risk mitigation strategies become crucial to executing the business plan correctly. Some ways syndication groups ensure these are mitigated include :
Renovation budget raised prior to start of project, not reliant on cash flow/rents
Multiple exit plans to the project
Experienced asset management team
Proven business model (units from previous owner already upgraded, proving target rental rates)
Conservative underwriting
It’s important to understand some of the strategies listed above when talking to a syndication group about a project. Different groups will have varying degrees of risk tolerance so be sure to align with one that fits your preference in this area.
In Final
It goes without saying, all investments have some risk and value-add is no different. However, value-add real estate projects give the opportunity to improve communities, change lives of tenants AND benefit investors in such projects. Being part of an investment that actually contributes to the overall way of life for a person is a very powerful thing and one of the main reasons to invest into real estate in our opinion.
As business owners and syndicators, as shown above, we also love the degree of control with “value-add business plans”. These value-add plays give an investor the ability to greatly influence the appreciation and outcome of a real estate project as a whole. Having greater control and options is always going to have a much better result for all involved.
Happy Investing!