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Imagine spotting an old bookshelf sitting out on the curb. You pull over to check it out, and since it’s in good shape, you proceed to lug it home and give it a fresh coat of paint.
A few years later, you sell the shelf to someone else who claims to have the perfect spot for it.
You took something that had been overlooked, committed some sweat equity, and breathed new life into it.
In this article we’ll dive into the basics of value-add real estate strategy, the risks involved, and the opportunities. While value-add strategies can be applied to any asset class, we’ll provide some specific examples for these asset classes:
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 commercial 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.
A great value-add property may have peeling paint, outdated appliances, or overgrown landscaping, which all affect the curb appeal and the initial impression that a potential renter or consumer will form.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:
We’ll take a closer look at three asset classes below, but remember these principles can be applied to nearly every commercial real estate asset class.
Common value-add renovations can include individual unit upgrades, such as:
In addition, adding value to exteriors and shared spaces often helps to increase the sense of community:
On top of all that, adding value can also take the form of increasing efficiencies:
When investing in Mobile Home Parks, a common strategy is to make improvements to increase the Net Operating Income and quality of life for residents. This can include:
Redeveloping properties to make them work better and handle more goods is part of the power behind value-add investing with industrial assets. Most properties are really just businesses, with opportunities to increase value and reposition for increased returns.
1. Strategic Value of Infill Properties:
Infill locations, especially those with older industrial assets, can be of significant strategic value due to their irreplicable prime locations, which inherently limit competition from new developments. Even when an asset is aging, a prime infill property with solid “bones” can give owners a definitive edge, with the potential for value to be added through strategic improvements, while ensuring the asset’s location remains a persistent draw.
2. Opportunities and Challenges in High-Demand Markets:
Certain markets offer specific advantages like historical rent growth and robust economic fundamentals, representing a sound investment opportunity. However, the recognition of this potential and subsequent high demand can make identifying potential development sites a considerable challenge, necessitating strategic, thorough planning and the capability to capitalize when opportunities do present themselves.
3. Changing Property Feature Demands:
Potential renters and buyers in the big box sector now seek features like ample trailer parking, multiple access points, and notably, ever-increasing clear heights. While there has been a modicum of obsolescence from properties developed years ago to those erected more recently, the utility and design of these properties have remained reasonably consistent, albeit with a distinct uptick in the demand for elevated clear heights.
4. Managing Risks and Identifying Inefficiencies:
Identifying inefficiencies in acquisition opportunities, such as current vacancies, pending rollovers, or significant capital needs, and then utilizing operational capacity to mitigate the associated risks is crucial. The confidence and competence of the operational and management team play a pivotal role in managing these leasing risks and ensuring that potential pitfalls are navigated effectively, to safeguard and enhance the investment value.
5. Technological Investments and Green Implementations:
Investments in technology, especially green technology, can significantly enhance the attractiveness and value of industrial properties. Implementing improvements in areas such as lighting, plumbing, solar power, and irrigation can make properties markedly more appealing to prospects, especially institutional tenants, potentially commanding higher rents and ensuring a shorter vacancy period during transitions.
6. Consistent Value-Add Strategy Across Market Cycles:
A consistent value-add strategy, involving the acquisition of assets at a discount to replacement cost and driving value through a strategic plan for each acquisition, can be effective across various market cycle phases. Such a strategy, which has proven successful for several decades, can anticipate continued growth and adaptability by aligning with the underlying market mechanics and investor objectives.
7. Evolution and Future Expectations in the Industrial Market:
The industrial market is experiencing a structural change in demand and usage patterns, moving from simply housing physical goods to incorporating more valuable activities. The transition from utilizing spaces merely for storage to integrating computers, sophisticated racking systems, and administrative functions means that efficient distribution spaces have become an essential component in contemporary supply chain strategies, underpinning profitability and operational efficiency for businesses.
The basic fix-and-flip of single-family homes is pretty familiar to most people, but when it comes to hundreds of units at once or a larger property with a single tenant (such as a retail facility), 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 commercial real estate property, such as a multifamily apartment building or a mobile home park, the vacant units are first. In a 100-unit complex (or 100-home park), a 5% vacancy rate means there are five empty units or homes, 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 happy 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 do move away, and it’s important for projects to account for a temporary increase in vacancy rates due to turnover and new leases.
When done well, value-add strategies benefit all parties involved. Through renovations, we provide tenants a more aesthetically pleasing property, with updated facilities 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 tenants is probably straightforward. But let’s dive into why value-add investing is a great strategy for investors.
First, Yield Plays
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 the monthly cash flow and potential future profits.
Yield play investments are where a currently-cash-flowing-property that’s in decent shape is purchased. The property provides a recurring stream of income from the rents collected – the yield. There is obviously 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 larger 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. 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 level of risk.
However, value-add deals also come with 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 hold 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 income 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 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.
In commercial real estate value-add investments, common risks include:
When evaluating deals as potential investments, look for sponsors who have capital preservation of the forefront of the plan and who have a number of risk mitigation strategies in place. These may include:
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.
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 cleaner, safer places to live and making tenants 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.
Here at Wise Stream Investments we provide multiple ways to leverage the power of real estate syndications in your investment portfolio so you can take advantage of real estate’s cash flow, equity, appreciation, and tax benefits.
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