What is Value-add Investment Strategy?

When investing in real estate using a value-add investment strategy, the investment property typically has little to no cash flow, at the point of purchase. However, the investor may add value to the property by resolving some of the physical or administrative issues faced by the property. These issues may involve the management of the property, physical maintenance and repairs, or occupancy issues.

The investor should be knowledgeable about strategic real estate to better understand how to manage and to optimise the property’s performance. Properties using the value-add strategy have the potential for high cash flow and returns after value has been added to it. However, it holds moderate to high risk, compared to core and core-plus investment strategies. This is because of the expertise required to successfully execute the value-add investment strategy. As time and effort is required to be invested into such a project, it is less ideal for investors seeking a passive form of income that requires low involvement.

The value-add investment strategy involves identifying properties that are in strategic locations but are not fully optimised in their financials, physical condition or operations. It is imperative for the investor to conduct real estate due diligence before acquiring the property and adding value to it. Value may be added by carrying out renovations, insourcing certain functions, making market adjustments, altering the tenant mix or managing the property expenses.

1. Renovations

A value-add property may be poorly maintained, behind in upkeep, or require larger scale renovations. These may cause rents to decrease below market rate, resulting in lower returns for the existing landlord, but providing the future investor with the opportunity to acquire the property at a discounted price. The investor may then invest additional capital into value-add renovation projects to make physical improvements to the property. This would ensure an increased net operating income, provided the operational expenses remain status quo.

2. Insourcing

In many investment properties, certain functions such as property management, are outsourced to external vendors. While this may be financially beneficial in some cases, investors or investment firms with the knowledge and resources to carry out these functions in-house may consider doing so, potentially at a lower cost than if it were to be outsourced.

For example, an investment firm with an in-house property management team may choose to release the external vendors and manage their properties through its internal property management team. As property management may cost up to 8-10% of the property’s gross revenue, investors can enjoy significant cost reductions by insourcing this function, directly increasing their net operating income.

3. Lease adjustments

Sometimes, the property’s cash flow may be limited by the terms of the lease, rather than by its physical infrastructure. In such an instance, the investor may renegotiate lease agreements and rental rates, to ensure that the property is commanding closer to the market rate. This can be carried out upon expiry of the existing lease, with the increased rental rates directly increasing the property’s net operating income.

4. Managing expenses

Investors who are well-versed in real estate should recognise approximate benchmarks for each expense category and manage these expenses, making adjustments for any expenses that fall beyond the expected range. The investor may review each expense and determine which expenses can be reduced without negatively affecting the property’s overall cash flow. If executed successfully , their net operating income can increase.

5. Tenant mix

Some tenants may be willing to pay a premium to be part of their ideal tenant mix. For example, a retail mall may have a large supermarket chain as its anchor tenant, with other tenants wanting to pay higher rental rates to benefit from the traffic generated by the anchor tenant. Investors can work with these tenants to earn higher rental revenue and secure higher occupancy rates, making the investment more stable and increasing net operating income.

The value-add strategy may be applicable for different asset classes, such as commercial real estate, residential real estate and office space.

The following example details the monetary value-added to a property and the corresponding increase in net operating income.

Before value has been added, the property has a net operating income of $350,000. By increasing the gross potential rent and increasing other forms of income such as late fees, the investor increases the gross operating income by $210,000; from $1,015,000 before the value-add to $1,225,000 after the value-add.

Expenses such as administration, payroll, marketing, repairs, utilities and insurance have also decreased through expense management and the property management expense eliminated through insourcing. Other costs such as property tax, depreciation expenses and operational reserves remain constant. This leads to a decrease in total expenses from $665,000 to $525,000, doubling the net operating income from $350,000 to $700,000.

These adjustments have also increased the cap rate of the property, further increasing its property value.

Pros of value-add investment strategy

1. High returns

Value-add properties can allow investors to gain higher returns through making improvements to the property, its management or positioning. Reducing expenses also decreases operating cost of the property, thereby increasing the net operating income to provide higher returns for the investor.

2. Increased cash flow

After the value-adding process, the property has an increased cash flow, which reduces the risk involved in the investment, providing higher returns for investors. These investors may invest in these properties over a shorter or longer investment period. The increased cash flow can provide consistent returns in the long-run, making long-term value-add properties a viable investment option.

3. Retains and increases property value

Value-add properties can typically be acquired at below market value due to their subpar performance. Thus, they are likely to retain their value or potentially increase in value after steps have been taken to add value to the property. Following this, the property may be sold at a higher price for investors seeking core or core-plus properties.

Cons of value-add investment strategy

1. Higher risk

Real estate investments employing the value-add strategy require a high degree of expertise and significant changes need to be made to increase the value and create a stable cash flow. Investors who are not able to successfully add value to the property may suffer losses rather than gains.

In addition, value-add properties are more highly leveraged than core or core-plus property types, increasing the financial risk should the project fail. Therefore, the investor has to consider the risks versus rewards to determine if they are willing to bear the higher risk of value-add properties, in comparison to the lower risk core and core-plus investment options.

2. Cash flow is not immediate

Even after the cash flow is stabilised, the investors often only have cash flow after two to three years. While the property may begin to generate higher revenue after the value-adding process, these may be used to cover the expenses incurred during the value-adding process and other loans. The investor only begins profiting after these costs have been covered, which is approximately two to three years into the investment period.

Why invest in value-add real estate investment strategy?

Investors should consider using the value-add real estate investment strategy, provided they have the necessary knowledge, experience and time to invest in the property. Investors or developers who have been exposed to value-add real estate projects can take the opportunity to apply their past experience and coordinate such an investment.

First-time investors or investors with minimal real estate investment experience should steer clear from such investments on their own. Alternatively, they may invest indirectly through real estate investment trusts (REITs) or directly through real estate co-investing.

About RealVantage

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.