In multifamily real estate, our Investment Strategy serves as a plan that describes “what” and “how” we plan to manage the investment and make our returns.
Investors will usually focus on one of three primary categories of assets for their Investment Strategy:
This article focuses on the Value-Add Investment Strategy
The Value-Add Strategy involves purchasing middle-market real estate assets that are already stabilized, but could still benefit considerably from certain improvements that would increase their value. The buyer is able to “add value” to the asset by improving it.
These are Class B or C properties with at least 85% economic occupancy (i.e., stabilized) and present specific opportunities for improvement. The goal of the improvements is to increase the property’s Net Operating Income (NOI) and therefore overall value, by increasing its gross revenue and decreasing its expenses.
The Value-Add Investment Strategy seeks to maximize the fact that the value of multifamily real estate is primarily based on what’s known as the Income Approach. The Income Approach is a method of calculating a property’s value based on its Net Operating Income and the Capitalization Rate. Specifically, the equation is as follows:
Value = Net Operating Income / Capitalization Rate.
Therefore, the higher the NOI, the higher the Value.
Gross revenue is most often increased by making changes that will bring in more rental income, as well as other types of income. This can be accomplished by upgrading the exteriors and overall look and feel of the apartment community, remodeling the interiors to bring them up-to-date, and adding amenities that are on par with the market.
With these improvements, the apartment community will be much more attractive to new tenants and can demand higher rental rates. The goal is to get the property at least 95% stabilized. Revenue can also be increased by adding fee-based amenities, such laundry services, storage units, premium parking, and others.
On the costs side, the expenses to manage and operate the property are heavily scrutinized and streamlined. Of course, this does not in any way mean cutting corners on quality or service, as that would be self-defeating in trying to attract good tenants. It does, however, mean eliminating waste and inefficiencies where possible. This can include items such as reducing unnecessary payroll, contractor, and vendor costs, and improving property management.
There are several major benefits of the Value-Add Investment Strategy. First, while there are physical improvements that need to be done, they are mostly moderate in nature. For example, paint, countertops, flooring, lighting, hardware, landscaping, and the like to bring the property up-to-date.
These are not the major deferred maintenance issues that typically must be replaced in distressed properties, such as replacing entire rooftops, HVAC systems, or rewiring the entire property. And if there are some of these major issues, they are few in number and not serious to the level of needing to be addressed immediately. Less major maintenance equals less costs and less risk.
Second, since Value-Add properties are at least 85% stabilized when acquired, it should produce cash flow from day one, again mitigating the investment risks.
Finally, being able to purposely make changes and improvements to increase the asset’s value is a major benefit. This is what’s known as forced appreciation. Its not appreciation waiting on market conditions to move in your favor. Rather, its growth in value that is purposely implemented through your investment strategy.
Of course, there are still risks involved with Value-Add Investments. For one, even if on a smaller scale compared to distressed investments, these properties still require upgrades and improvements that involve physical construction, projected timelines, scheduling, vacancies, and the like. Its not like purchasing a Turnkey investment where everything is already upgraded and running smoothly.
Additionally, careful attention must be given to the purchase price and overall budget of the opportunity. Pay too high of a purchase price or let the renovation budget creep up, and the upside potential could suffer.
Investing in Value-Add properties can be a “best of both worlds” scenario among the three Investment Strategies of Distressed, Value-Add, and Turnkey assets. With the Value-Add strategy, investors can often achieve a higher cash flow and upside potential than with turnkey investing, while mitigating the risks that come with more heavily distressed properties.
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