by Joe Firmin 3 Minute Read
Trash Day! When my parents lived in New Orleans serving the poor in the area, they would drive around on trash day in the nice neighborhoods and get some great furniture that people would be throwing away. Imagine spotting a cool mid-century modern dresser sitting out on the curb. You pull over to check it out, and since it’s in good shape, you proceed to shove it in the back of the van, lug it home and give it a fresh coat of stain.
A few years later, you sell the dresser to someone on Craigslist for $200. Cash money baby.
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, and shoot, business period.
The Basics of Value-Add Real Estate
In the case of single-family homes, the process of buying a run-down property, remodeling it, and then selling it for profit, is commonly referred to as “flipping.” Your sweat equity and ability to see a diamond in the rough is rewarded monetarily, and the new owner gets an updated, move-in ready home.
Value-add multifamily real estate deals follow a similar model, but on a bigger scale. Many units get renovated over a few years instead of just one single-family home over a few months.
A great value-add property may have peeling paint, outdated appliances, or overgrown landscaping, which all affect the curb appeal and the initial impression that a potential renter will form. Simple, cosmetic upgrades can attract more qualified renters and increase the income the property produces.
In value-add properties, improvements have two goals:
- To improve the unit and the community (positively impacts residents)
- To increase the bottom line (positively impacts investors)
Common value-add renovations can include individual unit upgrades, such as:
- Fresh paint
- New cabinets
- New countertops
- New appliances
- New flooring
- Upgraded fixtures
In addition, adding value to exteriors and shared spaces often helps to increase the sense of community:
- Fresh paint on building exteriors
- New signage
- Dog parks
- Covered parking
- Shared spaces (BBQ pit, picnic area, fire ring, etc.)
On top of all that, adding value can also take the form of increasing efficiencies:
- Green initiatives to decrease utility costs
- Shared cable and internet
- Reducing expenses
The Logistics 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 many units at once, the renovation schedule and logistics aren’t as intuitive. Questions arise around how to renovate property while people are living there and how many units can be improved at a time.
When renovating a multifamily property, the vacant units come first. In a 50-unit complex, a 10% vacancy rate means there are five empty units, which is where renovations will begin.
Once those five units are complete and as each existing resident’s lease comes due for renewal, they are offered the opportunity to move into a freshly renovated unit. Usually, residents are more than happy with the upgraded space and happy to pay a little extra.
Once residents vacate their old units, renovations on those now vacant units start, and the process continues to repeat until most or all of the units have been updated.
During this process, some residents do move away, and it’s important for projects to account for a temporary increase in vacancy rates due to turnover and new leases.
Sometimes, residents do not want an upgraded unit and do not want to move, but are willing to pay the increased rent – a win-win for the resident and the investors!
Why We Love Investing in Value-Add Properties
When done well, value-add strategies benefit all parties involved. Through renovations, we provide residents a more aesthetically pleasing property, with updated appliances and more attractive community space. By doing so, the property becomes more valuable, allowing higher rental rates and increased equity, which makes investors happy too.
The property-beautification process and the fact that renovated property is more attractive to residents is probably straightforward. But let’s dive into why value-add investing is a great strategy for investors.
First, Yield Plays – Quick Sidebar
To fully appreciate value-add investments, we must first understand their counterparts, yield plays. In a yield play, investors buy a stabilized asset and hold it for potential future profits.
Yield play investments are where a currently-cash-flowing-property that’s in decent shape is purchased and held in hopes to sell it for profit, without doing much to improve it. Yield play investors hold property in anticipation of potential market increases, but there’s always the chance of experiencing a flat or down market instead.
In a yield play, everything is dependent upon the market.
Now, Back to Value-Adds
Value plays and yield plays are opposites. In a value-add investment, significant work (i.e., renovations) takes place to increase the value of the property and doing such improvements carry a higher level of risk.
However, value-add deals also come with a ton of potential upside since the investors hold all the cards. Through actionable steps that improve the property and increase its value, value-add investors don’t just hold the asset hoping for market increases.
Rather due to the improvements, income is increased, thus also increasing the equity in the deal (remember, commercial real estate is valued based on how much income they generate, not on comps, like single-family homes), which allows investors much more control over the investment than in a yield play. It’s called forced appreciation.
Of course, a hybrid yield + value-add investment is ideal. This is where an asset gets improved as the market increases simultaneously. Investors have control over the value-add renovation portion and the market growth adds appreciation.
Now, before you get too giddy about the potential of a hybrid investment, there are risks associated with any value-add deal.
Examples of Risk in Value-Add Investments
In multifamily value-add investments, common risks include:
- Not being able to achieve targeted rents
- More residents moving out than expected
- Renovations run behind schedule
- Renovation costs exceed initial estimates (which can be a big deal when you’re renovating many units)
To mitigate the risks and meet the #1 goal – capital preservation, ensure the proposed business plan has a number of risk mitigation strategies in place. These may include:
- Conservative underwriting
- Proven business model (e.g., some units have already been upgraded and are achieving rent increases)
- Experienced team, particularly the project management team
- Multiple exit strategies (refinance, sale, etc.)
- The budget for renovations and capital expenditures is raised upfront, rather than through cash flow
Like a sweet supercar, value-add investments can be powerful vehicles of wealth, but they also come with serious risks. This is why risk mitigation strategies are important - to protect investor capital at all costs.
Recap and Takeaways
No investment is risk-free. However, when something, despite its risks, provides great benefits to the community AND investors, it becomes quite attractive.
Properly leveraging investor capital in a value add investment allows drastic improvements in apartment communities, thereby creating a cleaner, safer places to live and making residents happier.
Because investors have control over how and when renovations are executed, rather than relying solely on market appreciation, they have more options when it comes to safeguarding capital and maximizing returns.
This is a sweet win-win!
If you’re interested in learning more about investing in value-add investments and becoming a passive real estate investor in real estate syndications, consider joining the Freedom Network. It’s absolutely free to join with no commitment necessary. If you don’t join, we won’t be able to send you opportunities (sorry, SEC rules). So join today!