If you’ve been around real estate, you’ve probably heard the term “value-add”. It’s one of the most popular terms in the industry, used to describe investment styles, company specializations, individual projects, and properties. This post will explain what “value-add” means in real estate (and what it doesn’t mean), how it works, and why it’s so popular with investors.
On one level, value-add defines itself. You add value to a property. Easy, right?
The difficulty lies in how you add value. There are two ways to increase the value of a property:
Pure appreciation is out of your control – it depends on thousands of economic and social factors specific to a location, asset class, and public sentiment. Every investor loves it, but it’s not something you can control and therefore count on.
Improvements, however, are a way to force appreciation. This is what value-add refers to. You purchase a property with physical or operational issues and you fix those issues. In commercial deals, this leads to an increase in Net Operating Income (NOI) which increases the market value, For residential deals, you’re making the house nicer, which leads to a higher appraised value.
Be careful not to confuse value-add with “opportunistic” projects. While these projects meet the definition of improving a property, they involve a lot more than simple fixes, and carry more risk. An example would be repositioning an office building into multifamily or doing a full ground-up development on raw land. Some investors will use “value-add” to refer to opportunistic projects, but it’s misleading due to the risk and labor that comes along with the added complexity.
So what does a value-add project entail?
One of the most familiar examples is purchasing an older apartment complex with significant wear and tear (B or C class are the industry terms). There are thousands of these properties across the country, many owned by individuals or small investment firms. These typically rent at the market average or below, operate on high margins due to maintenance and turnover costs, and don’t have a strong online presence.
You negotiate a purchase price based on the current NOI, renovate individual units and common spaces, upgrade the payment and leasing systems, and get some high-quality pictures and video to improve online marketing. By the time you stabilize the property, your rents should increase and your expense margin should shrink. These factors grow your NOI, which translates to an increase in equity based on the market cap rate.
The above example highlights why so many investors search for value-add deals. It’s a proven gameplan to increasing cashflow and forcing appreciation in real estate.
It’s important to keep in mind, though, that any variables in a business plan can translate to risk. Some common mistakes in value-add projects include underestimating renovation costs, overestimating stabilized income, getting into trouble with tenants, neighbors, or local government, and discovering structural issues that slow down or even prohibit renovations.
If you’re comfortable with this additional risk in an investment, and have confidence in your ability to execute the business plan (or for passive investors, the ability of your GP), then investing in value-add projects can be a great route to growing wealth over time.