Value-add investments are the quintessential ‘good deal’ of real estate investing. They’re the next step up the risk-and-reward ladder of real estate investments.
Whereas turnkey real estate investments – the first rung on the ladder – provide a lower level of risk in exchange for a lower but predictable reward, value-add real estate requires investors to put more time and additional money into a property.
Selecting a value-add real estate investment is a mixture of both art and science. But when the right property is selected and the correct strategy is used, real estate investors can boost the value of their investment in a relatively short period of time.
How Is Value Added to a Value-add Investment?
Real estate investors looking for a value-add deal try to find a property that has some type of potential on which the seller isn’t able to capitalize.
Sometimes sellers lack the foresight that a changing real estate market demands. Sometimes they lack the funds needed to make capital improvements. At other times sellers simply lack the ability to properly manage their investment.
This is the ideal situation for the value-add real estate investor. Value is added to value-add real estate in three ways:
- Improving the operation of the property by increasing net operating income;
- Repairing deferred maintenance and wisely making capital improvements that will justify higher rents;
- Repositioning the property for a new use, or to attract a different category of tenants.
Incremental Revenue Increases and Repositioning Require the Right Strategy
Raising rents and more efficient property management increase the incremental revenue of the property, and raise the Net Operating Income (NOI.) There’s a minimal amount of risk involved in exchange for a higher property value from the boost in net operating income.
Property repositioning requires making extensive capital improvements and improving the operation of the property. Repositioning strategy has to be timed perfectly to match the forecasted conditions in the real estate market. While there’s more risk involved in repositioning a value-add property, it can also add the significant increase in property value that value-add investors look for.
Three Ways to Increase the Operating Income of Value-add Property
Generating more gross income is one way of adding value to a value-add investment. The three most effective ways to do this are:
1. Increase rents by giving tenants a reason to want to pay more
Sometimes rents in a value-add property are below market, but investors buying value-add properties shouldn’t count on simply raising rents to the market level. Upgrading interiors and renovating exteriors are two things that add value to a property and help justify rent increases passed through to tenants.
2. Create new income streams for the property
Finding ways to create new income streams is another key way to boost property value. Designating assigned parking spaces or installing covered parking in an outside lot are two low-cost ways to add value and generate new monthly parking dues from tenants.
Other ways to generate more gross income from a property include offering tenants a for-fee concierge service, day care facility, or pet walking and grooming service like those often found in coworking office facilities.
3. True-up CAM charges
Common area maintenance – or CAM – charges are building operating expenses passed through to tenants based on the percentage of the building they are occupying. CAM fees include items like property tax, building insurance, landscaping, and building utilities and are charged to tenants as a form of additional rent.
Sometimes tenants in a value-add property are being charged a lower common area maintenance fee than they should be. Auditing the accuracy of CAM fees and correcting any under billing to tenants is another way to generate additional income from a value-add investment.
Improving Property Management and Operations Also Adds Value to the Investment
Another successful value-add strategy is to review how efficient the property management team is and how effective the current leasing team is. Key metrics used to measure property performance include:
- Gross income per square foot or per unit, compared to similar properties in the market;
- Operating expenses as a percentage of revenue, versus property in the same asset class;
- Vacancy level of the value-add property, compared to similar properties;
- Absorption rates – or the time it takes to lease space – in the value-add property, compared to other property in the same submarket;
- Cap rates going into the value-add investment, and projected exit cap rates, once value is added.
Keys to Success Using a Value-add Property Investing Strategy
Value-add real estate investing is a time-tested strategy that works in all phases of the real estate cycle. New technologies, changing market conditions, and innovative property positioning will continue to offer investors buying value-add property opportunities to create new revenue and increase property values.
There are two keys to successfully using the value-add property investment strategy.
First, the investment objectives for the value-add property should be identified before the real estate is purchased. Value-add real estate investors holding the property as a long-term investment may choose to completely update the property and maximize the number of revenue streams, and enjoy the annual cash flow and reduced risk that the property will then provide.
On the other hand, investors purchasing value-add property as a short-term investment may find that leaving upside potential – in the form of updating left to be done or pending additions to the revenue stream – is better suited to the exit strategy for the value-add real estate investment.
Next, focusing on ROI by investing in property improvements that have a material impact on revenue increases. Spending money on upgrades that don’t generate an acceptable return on investment – or meet the objectives of the investment – will dilute the overall performance of the property.
