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What is a Value-Add Investment Strategy?

Value-add investing is a popular investment strategy among multifamily syndicators. The idea of value-add investing is simple, but when it comes to apartment complexes, it can become more elaborate than your typical single family fix and flip.

In this article, we’re going to explain what value-add investing is. We’re also going to dive into what the characteristics of a value-add property are, and we’ll break down the different aspects of a value-add strategy. By the end of it, you’ll see why this investment strategy is so popular, and is arguably the superior way to invest in apartments.

Value-Add Explained

Value-add investing involves an investment property that allows investors to increase the value of the asset by increasing its cash flow through remodeling, rebranding, or increasing the operational efficiency of the property.

Value-add investing is both an art and a science. There is a level of creativity required, and value-add investing can look different from one investor to another. The opportunities to add value can also range depending on the property type and the market.

Traits of a Value-Add Property

The remodeling plan of a value-add property can range from light renovations needed to a deep value-add property that needs extensive repairs.

A value-add property may have current rental rates that are below market rates. This means that similar nearby properties are charging more in rent than the subject property.

Occupancy rate is another factor that can signal value-add potential. If the property has a low occupancy rate, then that means it has the potential to generate more revenue.

Of course, a property that needs physical upgrades and is outdated offers investors with value-add opportunities.

Besides repairs and upgrades, a property may be run inefficiently by its current management. Therefore, there may be value-add potential at a property that is poorly managed. A better management team can increase revenue and decrease expenses.

Value-Add Strategy Breakdown (with Examples)

A value-add strategy is pretty straightforward. A multifamily investor will acquire an apartment complex at a discounted price. They will hold onto it for a certain amount of time, during which they will renovate the property and/or improve the operations in order to increase the overall value of the property and force appreciation. At the end of the hold period, the investor will sell the property in a better condition than it was in when it was purchased. This is similar to how a flipper fixes a house and then sells it in the single family space.

Adding value to a given property can take many forms.

  • An investor may implement a new property management company to improve the operational efficiency at the property.

  • Rebranding is also a way to reintroduce the property to a community and attract new residents, which can support their desired rent increases.

  • Interior and exterior renovations can justify higher rental rates as well. By upgrading the exteriors of the property, an investor can improve the curb appeal and attract new residents.

  • An investor may choose to change the vendors who provide essential services at a property, which can help them save money on these expenses, or receive superior results.

  • An investor may decrease the cost of running a property.

  • They can also evict non-performing residents so they can turn the units and rent the rooms out again.

  • Adding amenities such as a pool, dog park, community grilling area, or a playground can also add value to a property and justify higher rents. It can also help attract a better tenant base, who will be more likely to take care of the property and not miss a payment.

  • Implementing security measures such as a gate, more lighting, and cameras allows the investor to not only protect their residents and the property, but it can also attract better residents to the property and deter others.

  • Many times, a value-add strategy can also include light fixtures, adding covered parking, and improving the landscaping.

By implementing changes to the property, an investor can decrease the expenses at the property and receive more rental revenue. This will increase the asset’s cash flow throughout the hold period. When the investor is ready to sell the property, they can ask for a higher purchase price than they otherwise could have in the property’s original condition.

It’s necessary to note that these improvements not only benefit the investors who receive the returns, but it also benefits the community members who receive improved amenities and a higher standard of living. Residents can enjoy an aesthetically pleasant property with improved appliances and newer amenities. Investors can be happy that the property’s value has increased because of increased rental rates and increased equity.

What You Need to Know About Value-Add Investing

Keep in mind that an investor’s budget needs to accurately reflect the full scope of work they intend to complete at the property. Oftentimes, an investor will underestimate the costs of implementing their value-add business plan and construction project required to achieve their projected returns.

Also, the condition of the property plays a major factor in how much risk is associated with the project. The more distressed the property is, or the more work required to stabilize it, the more risk involved. That is because there is more capital needed upfront in order to meet projected returns. But, distressed properties also typically involve higher returns.

The renovations involved in a value-add deal do bring some level of risk. Risks involved in a multifamily value-add deal include an inability to raise rents to the desired level, higher vacancy rates than expected, delays in renovation timelines, and higher renovation expenses than the investor budgeted for.

There are ways to mitigate these risks.

  • Conservative underwriting is an essential way an investor can mitigate risk during a value-add multifamily deal.

  • Having a proven business model in a given market is also helpful, because it shows that the investor knows what they are doing, and has done it before. There is a historical track record that proves they have the experience, and that this type of business model works in the market.

  • Having a seasoned sponsorship team is key, as well. No investor will be able to predict the future, but an experienced investor has likely had to deal with unforeseen challenges in the past.

  • Not only is the team important, but it’s also critical to have multiple exit strategies. This allows the investor to pivot if they can’t execute on their initial exit plan.

Most value-add business plans take time to implement. As a result, cash flow is typically low at the beginning of the hold period. The majority of the capital will be going towards implementing the business plan so that the property can be stabilized and cash flowing as soon as possible. While a stabilized property may cash flow sooner than a value-add property, the value-add property is more likely to have higher appreciation. This is because the investor has control over the value of the property, and by improving the condition and operations of the property, they can create value and force the property value up.

Stages of a Value-Add Deal

Property upgrades typically begin with the vacant units. This is because they are the quickest to turn. They are also the easiest ways to increase the rental revenue at the property. Rather than having to evict a resident, all the investor needs to do is implement the upgrades and find a paying resident to fill the unit.

As leases come due, the investor can relocate the residents to newer units and go begin renovating the older units. Once renovations are finished, they can rent the units out at the higher rental premium. This process would continue until all of the units are updated.

Value-Add vs Yield Play

Yield play investments involve an asset that is stabilized and held for monthly cash flow and potential future profits. With this business model, the property is currently cash flowing, and typically doesn’t require extensive upgrades. The rental payments are the yield and are collected as a recurring stream of revenue. The main goal of this strategy is to make a profit at the end of the hold period upon sale. Yield play deals typically don’t involve renovations or forced appreciation, but instead rely on natural appreciation of the market.

In contrast, value-add investors plan to complete extensive renovations at a property to force appreciation. The investors have more control in value-add deals than in yield-play deals. An investor can influence the value of the property by forcing its value to increase through renovations and decreasing costs. Keep in mind that commercial properties are valued based on how much revenue they generate, not what other properties in the area are selling for like single family homes.

Value-Add Isn't Going Anywhere

As mentioned previously, there are many benefits to value-add investing. Successful value-add properties can offer higher returns than other strategies because of the investor’s ability to force appreciation of the asset. This does involve more risk, but these risks can be mitigated through strategy and preparation. The investor can also maneuver through economic changes with more versatility than other investment strategies because the business plan isn’t solely dependent on market trends. This is why value-add investing will remain a timeless strategy that will continue to be prevalent among seasoned investors in the multifamily space.

As time passes, properties will experience natural wear and tear, and value-add investors will be there to acquire them and implement their astute strategies to maximize returns and bring value to their investors and the communities they invest in.

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