When speaking to commercial real estate investors one may often hear the term “value add”. What does that really mean and how does it impact the property, business plan, and investment performance over time? In today’s quick tip article we will explore just that.
In simple terms, as the name implies, the value add approach identifies ways to add value to the property with the goal of improving cash flow and capital appreciation in an effort to achieve the property’s full potential value.
Such value add can take the form of (i) operational enhancements such as growing revenues by increasing rents (e.g. bringing rents to market), creating additional income streams (e.g. pet fees), or optimizing expenses (e.g. leveraging economies of scale, implementing smart tech to reduce expenses); (ii) capital improvements (e.g. updating interiors or catching up to deferred maintenance), or (iii) total repositioning (aka heavy value add, which usually combines operational and heavy capital improvements often making the property appealing to a more affluent tenant base).
When it comes to capital improvements, evaluating the project’s ROI is important when making a decision on how much and what types of investment to make in the property. Underinvesting in upgrades can leave potential revenue increases or expense reductions on the table, while overspending on improvements that do not materially increase revenue or reduce expenses can dilute returns.
Keeping the potential value at exit (aka as reversion value) is also important. More specifically, while upgrading 100 percent of the units might maximize potential revenues, doing so may completely exhaust the asset’s upside potential thereby leaving no (or nearly none) value add for a potential buyer (often referred to in the industry as “leaving meat on the bone”).
Value add strategies can take different forms – light value add or heavy value add. Light value add (aka stable value add) would revolve around operational improvements and/or minor capital improvements. Heavy value add (aka as major repositioning) would involve heavy capital improvements (e.g. renovating the property to the studs, adding staff or additional security, implementing heavy exterior updates.
By maximizing the property’s full potential value, the value add strategy improves the property (and the area) and achieves what is known as forced appreciation. Such forced appreciation can serve as a hedge against market fluctuations. Let’s see how that can actually play in practice.
For example, let’s assume you purchase a 50-unit property that historically generates annual NOI of $100,000. And let’s assume market cap rate at that point of time is 5.00%, yielding property value of $2MM.
Let’s assume through operational improvements you increase NOI by $50/unit/mo. This small increase would equate to a $30,000 improvement in NOI.
Assuming no change in market, you just increased the property value by $600K to $2.6MM (see calculation below or refer to our prior article)!
Now what if the market contracts or there is a downturn and market cap rates increase from 5% to 6%. Your operational/NOI improvements yield a value of $2.16MM vs. $1.67MM if you sat and did nothing.
Successful implementation of the value add model comes with its own risks and hurdles such as the risk of poor execution, the need for a high level of coordination (knowing the market, being creative, communicating with partners and vendors), upfront budgeting with a high degree of accuracy. Being slightly off budget may call for tough decisions such as modifying the initially planned updates or even worse – a capital call from the management team (GPs) or passive investors (LPs). A hot market can often hide such deficiencies or poor execution – as Warren Buffet once said: once the tide goes down, you will know who was swimming naked.
Investment in multifamily and uncovering the property’s untapped potential takes market knowledge, creativity, and strategic discipline. If used right and with proper planning and diligence, the value add strategy can be a powerful tool allowing one to focus on what one can control by improving the property and local communities, while delivering strong returns to investors and hedging against market fluctuations (that are often outside of one’s control).
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.