Value-add investing as a commercial real estate strategy is no longer a novel idea. As commercial real estate investors navigate today’s low-yield market environment, they are moving away from the stable core commercial real estate assets that are generating unsatisfactory yields and pivoting into alternative total return strategies.
In recent years, a growing number of commercial real estate investors have been shifting focus to value-add investing strategy – purchasing underperforming assets at a discount and seeking to capture hidden value through property upgrades and renovations. Upon improving the property, a value-add investor expects to stabilize rent rolls and generate increased net operating income, then exit the investment by selling the property to another buyer – looking for a steady income stream – at a premium.
A growing number of high net worth and family office investors are flocking into value-add multifamily acquisitions. Value-add apartment sales have totaled $32 billion in transaction volume, representing 16% of total U.S. apartment transactions in 2018 according to Real Capital Analytics. The recent job growth trend, healthy consumer consumption, and stable occupancy levels still provide a solid foundation for the investment thesis. But as the bull market marches on, opportunities to acquire existing properties have become increasingly competitive while the heightened demand for value-add properties is beginning to erode return potential in some primary markets. Finding the right value-add investing opportunity that generates “deep value” can be challenging, but can still offer the potential for healthy yield in certain markets at this stage of the cycle.
Finding the Right Market for Value-Add Investing
Value-add investors not only need to identify the right market – where acquisition can be carried out at a reasonable discount today – but also forecast the market outlook and find a market where conditions should remain favorable upon exit. Acquiring an asset at a deep discount will not mean much if, upon exit, the ultimate sell-out value does not justify the acquisition cost and renovation expenses.
Primary markets where value-add investing has worked in the past are now overpriced due to a substantial flow of capital from institutional players. Moderating rent growth in these primary markets can hinder value-add investors’ ability to increase rent upon completing the renovation. Value-add multifamily investors need to focus on markets where there is still room for rent growth, and that do not attract much competition but still exhibit strong economic fundamentals and sturdy demand for multifamily housing.
Fortunately, certain neighborhoods in secondary and tertiary markets can still accommodate a sound middle-market value-add investment thesis. These sub-markets are located near the urban areas of expanding secondary and tertiary cities that are experiencing unprecedented growth in technology, healthcare, finance, and other emerging industries. These cities, such as Nashville, TN, Raleigh-Durham, NC, and Austin, TX, have successfully unlocked economic growth potential from a highly-educated workforce and other demographic advantages, but have also witnessed the cost of living rapidly outpacing average wage growth. In these markets, rent growth fueled by an overheating multifamily market and lack of rental housing supply has prompted many young and lower-income workers to move from urban cores to more affordable submarkets surrounding downtown. These submarkets – located five to ten miles from the central business district – benefit from strong economic trends and job growth in the urban area, while offering favorable acquisition cost for investors and the room for rent growth.
Finding the Right Value-Add Investment Property.
Focusing on the right market to carry out value-add investing is the “top-down” component of the strategy, but the “bottom-up” component, is equally critical: performing property-level screening and discerning acquisition opportunity on an asset-by-asset basis. Firms can screen opportunities by looking for undervalued, underperforming assets in areas they deem attractive. Based on the value-add investor’s preferences and real estate expertise, each investor can also factor the property’s size, age, layout, amenities, and location into consideration.
Selecting the right value-add acquisition opportunity is by no means picking low hanging fruit. While many properties can qualify for this strategy purely based on the value or condition, some properties can be too expensive to repair or functionally obsolete. What appears as a “deep-value” opportunity can easily be a “value trap” in disguise.
The tradeoff here, thus, is potential income versus renovation risk. Typical Class-A buildings in a city center, though well maintained and stable, typically offer little room for rent increase. These newly completed assets are also more vulnerable to new construction, directly competing with new supply coming into the market, which can make maintaining occupancy and rent increases an uphill battle especially in a trending, over-supplied market. In contrast, Class-Cs charge below-market rent but with lower tenant turn over, investor’s ability to increase the rent is limited by potential tenants’ willingness to pay. Considering the main discount factors on these Class-C multifamily buildings are invariable property characteristics such as layout and location, apartment renovations alone will not be conducive to attracting a new group of tenants who are willing to pay high enough rent that can justify the renovation cost.
Value-add investors can strike a balance between cost and value potential with Class-B assets. Cap rates for Class-B value-add investment properties are more attractive than those of core, Class-A assets. Class-B assets offer more inherent room to raise rents and reduce operating expenses in comparison to Class-A assets, which make them less dependent on cap rate compression. By revamping each unit, common area, and the property exteriors, Class-B multifamily investors can offer tenants high-quality housing options without costing Class-A rent, justifying rent increases and drawing potential tenant demand from those who are seeking high-quality housing without breaking the bank.
|Class A||Class B||Class C|
|Age||Less than 10 years||10-40 years||30 + years|
|Rent||High, little room for growth||In between, potential room for growth||Low, below market|
|Tenant||Mid to high income||Middle-class||Blue-collar, workforce housing|
|Maintenance||Well maintained, newest||Reasonably well-maintained||Needs improvement|
|Layout||Most current and upscale||Reasonably up-to-date||Obsolete|
After preliminary screening and identifying acquisition targets, it is critical that the sponsor performs thorough due-diligence and gain a solid understanding of a property’s physical condition. Undiscovered structural flaws and other hidden issues can lead the project astray from the original underwriting and jeopardize the predetermined budget. In order to avoid exposing the investors to cost overrun and delaying the stabilization, the sponsor must preemptively remove any surprise and account for any renovation challenges upfront in the underwriting prior to acquisition. This is the part of value-add investing where manager selection becomes most critical. Passive investors must carefully select investments based on the sponsor’s real estate experience. Investors need to evaluate whether the sponsor is capable of performing thorough due diligence, comprehensively assess the property condition, and make the right judgment call in asset selection. In the middle-market transaction where assets are often inefficiently priced, passive investors need to rely on institutional sponsors that can leverage deep experience, negotiation power, information advantage, development expertise, and brokerage connections to identify the right acquisition opportunity and execute it in a right way. At EquityMultiple, we seek to partner with experienced sponsors. We perform in-house sponsor-level and transaction-level due diligence to provide another layer of protection to investors seeking to harvest the benefit of value-add investing opportunities.
Finding the Right Value Creation Plan
Value-add multifamily projects can entail a wide range of business plans depending on the target tenant, building size, and investor’s competencies. Experienced value-add investors also closely consider how much renovation risk they are willing to accept and how much they can feasibly spend per unit.
As noted above, Class B targets for value-add improvement can be a decade old or up to 40 years old. Even at the newer end of this spectrum, it is likely that the target property contains dated appliances and features, including but not limited to subpar electric stoves, inefficient single-pane windows, dilapidated carpeting, unattractive laminate countertops, ineffective plumbing, heating, and air-conditioning. Given improvements in the manufacturing of these features, value-add investors can often upgrade these facets of a property’s units at sufficiently low cost, especially when they are able to make these capital improvements at scale across a large number of units. Furthermore, improving electrical systems, HVAC and heating, and insulation can also reduce utility costs, and considering that states and local governments offer various utility rebates to promote the installation of renewable energy systems and energy efficiency measures, these improvements can offer a property-level improvement in NOI.
Value-add investors can also consider material upgrades to the exterior and common areas of Class B properties – enhancing the “curb appeal” of the property as a whole. This could entail improved landscaping; painting; or addition of amenities like a pool or a clubhouse. These upgrades further enhance the appeal of the property to target renters and can drive increases in rents. Exterior improvements, in particular, can improve the marketability of the property, allowing the investor to more broadly and effectively market units, create more demand, and mitigate vacancy risk.
Besides physical renovations, value-add investors should not sleep on operational enhancement opportunities. Adjustments to property management can drive some of the quickest improvements in net operating income. Investors can ensure a sound business plan by parlaying interior and exterior upgrades with improved services for residents, tenant communication, and marketing efforts. Starting from the top-line revenue, experienced property management can augment the value-add investment plan by making impacts on each line of the income statement. Property management maximizes rent yields via tenant management and analytics, attracts high-quality tenants, and minimizes the loss from long vacancies, smoothing the top-line revenue as the value-add property transitions from the renovation phase to the stabilization phase.
Most Class B properties that are viable targets for value-add improvement were once Class A, with amenities that appealed to the Class A renters of the day. If the renovation plan calls for updating units to serve as workforce housing, the investor can create value and ensure consistent demand by adding amenities to serve this renter population. Depending on the location, this might include childcare, transportation assistance, or career services.
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