Renting out the basement in my home was my first foray into the world of income real estate. That was where I first discovered the power of owning an asset and earning money by letting other people use the property. So imagine being in my shoes, staring at your old basement, seeing that it had the potential to bring in some extra cash, and then pursuing this wild idea to transform it into a place someone could call home.
A few years later, I sold that property and made some money off of it because people were looking for in-law suites and multi-use properties.
I took something (my basement) many people have no desire to touch and invest money into, and I brought it to life. This is the essence of value-add, and it’s a commonly used strategy in real estate investing.
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 fix-and-flip. 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 massive scale. Hundreds of units get renovated over years at a time instead of just one single-family home over a few months.
An excellent value-add property may have peeling paint, outdated appliances, or overgrown landscaping, which all affect the curb appeal and the initial impression that a potential renter will form. However, simple cosmetic upgrades can attract more qualified renters and increase the property’s income.
In value-add properties, improvements have two goals:
- To improve the unit and the community (positively impact tenants)
- To increase the bottom line (positively impact the 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, 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 the renovation schedule and logistics aren’t as intuitive when it comes to hundreds of units at once. Questions arise around how to renovate property while people live there and how many units can be improved at a time.
When renovating a multifamily property, the vacant units are first. For example, in a 100-unit complex, a 5% vacancy rate means five empty units, which is where renovations will begin.
Once those 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. Usually, tenants are more than happy with the upgraded space and glad to pay a little extra.
Once tenants vacate their old units, renovations ensue, and the process continues to repeat until most or all of the units have been updated.
During this process, some tenants move away, and projects need to account for a temporary increase in vacancy rates due to turnover and new leases.
Why We Love Investing in Value-Add Properties
When done well, value-add strategies benefit all parties involved. For example, we provide tenants with a more aesthetically pleasing property with updated appliances and more attractive community space through renovations. 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 tenants is probably straightforward. But let’s dive into why value-add investing is an excellent strategy for investors.
First, Yield Plays
To fully appreciate value-add investments, we must first understand their counterparts, yield plays. Investors buy a stabilized asset and hold it for the monthly cash flow and potential future profits in a yield play.
Yield play investments are where a currently cash-flowing property in decent shape is purchased. The property provides a recurring income stream from the rents collected – the yield. There is a hope to sell it at some later date for a small profit, but there is no business plan to renovate, force appreciation, improve the asset and realize a more significant gain at sale. 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.
Now, Let’s Get Back to Value-Adds
Value plays and yield plays are different. For example, in a value-add investment, significant work (i.e., renovations) increases the property’s value, and making such improvements carries a level of risk.
However, value-add deals also have a ton of potential upside since the investors hold all the cards. Through physical action steps that improve the property and increase its value, value-add investors don’t just keep the asset hoping for market increases; they force increases through improving the asset, raising rents, and lowering expenses.
Through property improvements, income is increased, thus also increasing the equity in the deal (remember, commercial properties are valued based on how much revenue they generate, not on comps, like single-family homes), which allows investors much more control over the investment than in a yield play.
Of course, a hybrid yield + value-add investment is ideal. This is where an asset gets improved, cash on cash yields are high, and the market increases simultaneously. Investors control 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 target rents
- More tenants moving out than expected
- Renovations running behind schedule
- Renovation costs exceeding initial estimates (which can be a big deal when you’re renovating hundreds of units)
When evaluating deals as potential investments, look for sponsors who have capital preservation at the forefront of the plan and several 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
- The budget for renovations and capital expenditures is raised upfront, rather than through cash flow
Value-add investments can be powerful vehicles of wealth, but they also come with serious risks. This is why risk mitigation strategies are essential – to protect investor capital at all costs.
The Hidden Value in Value-Add Properties
Investments always have risks. However, there are some risks worth taking.
One way of looking at things includes working, living, and feeling the way you do now for the next ten or more years. You do have the opportunity to just keep your train rolling with limited free time and hardly any hope for ever actually achieving the life you really want for your family. However, if that’s not what you envisioned, something’s got to change.
Alternatively, you have the chance to test and try investing in one real estate deal at a time, pursuing financial and investing self-education along the way, and the opportunity to discover a passive income stream that could be the key to unlocking true financial independence.
When it comes to investing in apartment buildings and adding value to the property, the benefits the community gains AND the rewards investors earn make it a pretty attractive deal from every angle.
Value-add investments allow for improvements in apartment communities and create a cleaner, safer place to live, and tenants are often happier. We have the opportunity to bring improved living conditions to the table which help tenants take pride in their community, and, in exchange, reap the rewards of greater cash flow and a higher overall property value because of it.
Since investors like you and I have some influence in how and when the renovations are conducted, there are more options to safeguard capital and maximize returns than with a simple buy-and-hold strategy toward appreciation.