Value-Add Real Estate, Defined
Passive real estate investors have the option to invest in the full spectrum of commercial real estate offerings and asset types, depending on their individual goals and risk preferences. Some may be drawn to a preferred equity investment in an office or industrial property, while others are more interested in an equity investment in a multifamily building. In this article, however, we’ll focus specifically on value-add real estate–a category of investment that appeals to those who are less risk-averse, who are motivated by greater upside potential, and who understand that a little TLC can go a long way.
If you’re curious about investing in value-add real estate, here’s what you need to know:
What is Value-Add Real Estate?
Value-add properties have existing income, but require some improvements to provide attractive returns. In their current state, they may be a bit run-down, or poorly managed. But operators who acquire these properties see their potential. With a few upgrades, operators are able to attract higher-quality tenants, charge more rent, and increase their property’s net operating income (NOI). Real estate developers and sponsors who are experienced at investing in value-add properties can see a through-line to both appreciation and income, drawing up precise business plans to deliver value to both co-investors and tenants.
How Risky is Value-Add Real Estate?
Value-add properties can be found in the upper-mid portion of the real estate risk spectrum, providing moderate to high risk for moderate to high returns (see below). Both the risk and return potential is largely due to the nature of the renovations required. Curing deferred maintenance, for instance, can be expensive and time-consuming. On the other hand, performing this maintenance can significantly increase the property’s value, making it a worthwhile endeavor.
If this level of risk does not seem right for your current strategy, consider these other asset types:
- Core Real Estate: At the low end of the risk spectrum, core properties are typically located in Tier I or Tier II markets with high demand. The assets are in good condition, and are leased to quality tenants. Investors often employ a “buy and hold” strategy.
- Core-Plus Real Estate: Similar to core real estate, these properties are often in desirable markets, but involve slightly higher risk. For instance, the property could benefit from minor renovations, or it may not be fully leased.
- Opportunistic Real Estate: As the name implies, opportunistic properties provide the highest risk, along with the highest returns. Investors should note they may need to hold these assets for quite some time, as operators build a project from the ground up, or perform significant rehabilitation.
Passive investors who demonstrate interest in value-add real estate should consider whether Sponsors have prior experience executing on business plans that entail potentially complex renovations or capital improvements. Value-add projects involve more uncertainty and generally longer hold periods before a target exit than core or core-plus investments. Hence, the range of possible IRRs on a realized value-add project is generally greater than for more conservative strategies.
That said, EquityMultiple’s Real Estate Team does significant diligence to ensure that Sponsors have a strong business plan. Stress testing sponsor assumptions and considering a range of outcomes becomes all the more critical with value-add investments—you can expect to find this scenario analysis in our diligence items. Our Asset Management Team then monitors assets from close through exit, seeking to maximize investor returns and mitigate risk.
Value-Add Real Estate Examples
Wondering what value-add real estate entails, and if the strategy is worthwhile? Here are a few examples from prior EquityMultiple investments:
Property 1: Interior Upgrades
In this case, the Sponsor’s goal was to add value by upgrading individual units within this property. The newly renovated units featured new cabinets, granite countertops, stainless steel appliances. The Sponsor also installed new high-end lighting and plumbing fixtures, backsplash tiling, washer-dryers, dishwashers, and hardwood flooring.
Property 2: Common Area Improvements
At the time of investment, rents at this property were below market. The Sponsor identified an opportunity to renovate the property’s common spaces, upgrading amenities and deferred maintenance that included a new pool deck and club house, new outdoor kitchen, fitness center, dog park, and significant landscaping upgrades.
Now, let’s do the math. We’ll say this operator acquired the property for $100,000 per unit. Each unit rented for about $800, approximately 15% below market comparables. Upon renovation of 100% of the units, at a cost of $15,000 per unit, they can increase rents by 40%— directly in line with market comps for similarly renovated properties. After a 4-year target hold, which includes a 3-year renovation and lease-up period, they plan to sell the property at a projected 6% cap rate. Sounds pretty good, right?
Of course, the main benefit of making these improvements is the impact on the property’s NOI. Operators can often acquire a mismanaged property at an attractive cost basis, and then sell it for high returns later once the new value is evident.
For a more detailed overview of how to find the right multifamily value-add investment, please read this article.
The Bottom Line
For many passive real estate investors, the benefits of value-add properties are clear. There is more risk associated with this asset type than a core or core-plus investment; however, the potential returns can be hard to pass up. Each individual investor must decide for themselves whether a project’s returns are appealing relative to the risks. This can depend on a number of factors, including:
- Cap rate movement
- Sponsor experience
- Current rents vs. market rents
- Market fundamentals
When evaluating a potential investment, pay close attention to the Sponsor’s business plan. Experienced operators should clearly outline why a property is slightly neglected or undervalued, as well as how they can increase its NOI.
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