What is Value Add Real Estate?
Investing in real estate, like investing in any other asset class, will always involve a trade-off between risk and reward. Value Add Real Estate is an investment style at the higher end of risk and return curve compared to core and core-plus real estate strategies. As the name suggests, value-added involves creating value either from smart asset management to create income where it did not exist previously or improve the asset in a cost-effective manner and then flipping the transitioned asset to the next buyer.
Value add and opportunistic investment style can be applied by small and large investors alike, from individuals trying to create value in their rental property to value add private real estate funds managed by large real estate private equity firms.
Cashflow is one of the most important metrics to measure value in real estate and if the next buyer can see that cashflow then it is easier to crystalize the capitalized value of the income stream. Value add strategies in our view represent this to the core and earns most of the return from capital appreciation which can be lumpy vs core return which is made up mostly of income. This is why this investment style is more suited for close ended funds than open ended perpetual real estate investment funds.
List of Value Add Strategy
There are many ways of creating value in real estate. The common thread amongst all of the strategies below is buying an asset and convert aspects of the property previously not recognized (or too difficult to implement) into income or improvement in quality. A corresponding stream to this is implementing upgrades in a cost-efficient manner better than a competitor.
This might sound like a general investment strategy for all real estate investments. In the value add real estate context the main difference is the scale of change and speed of execution and riskiness of executing the investment plan.
Rental Properties Value Add Opportunities
In the rental property, context value add can mean converting the garage into another living room or an extra rental area. But a more comprehensive view of the value add could be an extension of the property to create a separate area for rental income.
From one perspective, the first is a qualitative addition to the property which can be hard to quantify. The latter example, the value can be quantified as the increase in income can be added directly to the property’s total annual cashflow and divided by the cap rate.
For example, if the extension area’s rent is $100 a week, assuming no additional operating expenses. The total rental income in a year will be $5,200 and divided by a 5% cap rate result in ~$100k increase in value added to the house. The owner will incur costs to create the extension area but if we assume a 20% development profit, then it is still worthwhile if the contractor and build cost are only $80k.
Commercial Real Estate Value Add Strategies
Value add is perhaps more well known and easier to quantify in commercial real estate strategies. The range of commercial real estate value add strategies revolves around repositioning buildings by improving the quality, amenities and income profile of the asset.
- Adding additional floors to the building or convert unused space into lettable areas. Clean up and improve the flow of the garage areas which opens up more leasable parking slots.
- Release existing vacancy in the building. A level of occupancy that poses a significant income risk profile and represents value add should be more than 30% vacancy rate. This included buying short leased building and extend the lease profile. The resulting greater certainty of cashflow will sharpen the cap rate. The value is created by either improving the leasing campaign or because the investor knows the target market and tenant better vs the previous owner.
- Improve the building operations and reduce unnecessary expenses. In markets where the rent is a gross rent and the landlord is directly responsible for building operation costs, any expense savings goes directly to the bottom line and in turn the asset. This can be achieved by improving energy efficiency, reduce waste and cutting unvalued or unnecessary services.
- Manage building upgrades through more cost-effective or better asset management expertise. If the asset requires a necessary upgrade, it is usually priced with the expected capital expenditure priced in but if you can do the works quicker or cheaper for the same quality then that can be a source of value add. Value can be created if the investor is experienced in managing contractors and has a good handle on costs.
In total, the building could be under rented and a combination of a better management approach, leasing strategy and improvements can result in an achieving market or higher rent. The value created is a balance in managing the works, running the building and budgeting the necessary capital works and execution of the leasing strategy.
Notably the leverage adopted in these type of strategies are also higher than at 50% to 70% of loan to value. More experienced investors will also include mezzanine loan in the capital stack to turbo charge the return.
The above list of ways to add value in real estate relates to aspects of the investment within the control of the investor.
There is also an aspect of value add real estate which involves taking real estate market risk. This involves riding a cyclical or secular trend that a particular area is undergoing but is not yet widely recognized. Such as buying in markets that are undergoing transformation or demographic change on a micro or a macro level.
On a micro level, this could mean a particular area of the city is seeing improvement through gentrification or better public transport access. On a macro level, this could mean a whole region is undergoing a shift as best represented by a demographic shift. Improvement in population growth can be a powerful tailwind to real estate as the resulting increase in people always means an increasing demand for real estate. We like markets where the supply response is expected to be muted or cannot keep up with the demand.
The outline of value add strategies shows there is a variety of options to create value in real estate. The best value add investors adopt a combination of strategies above. There are many avenues where things can go right or wrong such as getting a good price on the deal, getting the rents right in the underwriting and budget of the capital expenditures correctly. The more experienced investors will know based on their prior investments the ins and outs but even the pros can get it wrong. In our view, value add real estate investing is one of the most interesting risks adjusted approaches in investing in real estate.