What is a Value-Add Investment Strategy?
The sponsor is the most critical element of any investment opportunity because the sponsor is creating the opportunity, obtaining financing, managing the property, and attracting investor capital. But what is the potential “opportunity?” The opportunity is the multitude of multifamily properties that are poorly managed, have deferred maintenance, no business systems in place, have higher vacancy rates than the market, rents below market value, or fees not assessed. The significant number of these underperforming and inefficiently operated properties in the U.S. are prime opportunities for the sponsor to implement a value-add strategy to maximize income and deliver returns to investors.
Because commercial real estate is valued based on the amount of income generated, the asset becomes more valuable with income growth. Each asset should be thought of as a functioning business, and the goal is to make each asset into a better business that will be highly valued by investors. Therefore, the sponsor will take a poorly run operation and turn it into a well-run company, which is also backed by real estate (what a nice bonus!).
Improving the appearance of an older property should be a high priority. The outside appearance of the property is influential to prospective tenants who will be drawn to a positive first impression. Simple items of work such as painting the facade, improving the landscaping, and the common areas are very beneficial. These improvements add to the curb appeal and help to increase the occupancy rate and the bottom line of the business.
A well-planned renovation will typically start from the exterior of the property and progress to the interior of any vacant units. Occupied units will be renovated when existing leases expire. Only renovations that add value that renters will pay for should be utilized. In the case of assets like multifamily and senior living facilities, these could include updating the following: kitchen cabinets and countertops, carpeting and flooring, light fixtures, and window coverings. The extent of the renovation will be partially dependent on the existing condition of the property and the degree of the intended repositioning (e.g., moving from Class “C” to Class “B” will be different than moving from Class “B” to Class “A”). It is crucial to carry out only work that will produce the highest return.Multifamily Value-Add
Many older properties are not individually metered, and inefficiently managed properties may not have a system of billing back any owner paid utility costs to the tenant. A new owner should look to shift the responsibility of these expenses to the tenant. One method is to implement a ratio utility billing system (RUBS) formula that estimates the amount of tenant consumption based on variables such as the number of occupants and square footage of the unit. Depending on the number of units and the current cap rate, an additional $30/month recouped by the owner could add tens of thousands of dollars to the property value.
Laundry service is sometimes an overlooked component of a value-add strategy despite there being several options that can be executed. For instance, the owner may contract with a laundry service company that furnishes and maintains the washing and drying machines and splits the revenue with the owner. Another option would be for the owner to remove any on-site laundry facilities and install a washer and dryer set in each unit if the property classification would justify this (e.g., Class “B” and higher). Washer and dryer installations would be performed as part of each unit’s renovation. Also, the former laundry building could be partitioned into individual storage units and rented to tenants, becoming a perpetual income generating on-site self-storage facility.
Depending on the specific circumstances of the property, owners should look to implement fees such as the following: prospective tenant application fees, pet fee, month-to-month fee, lease termination fee, use of additional storage room fee, additional assigned parking or use of carport/garage, and nonsufficient funds (NSF) fee. The supplemental income from these ancillary fees can add tremendous value to a multifamily asset.
These value-add components are intended to be an overview and not comprehensive of the ways to add value. Innovative sponsors will find ways of increasing efficiency and making constant improvements to the asset.Value-Add Process
Once the asset is repositioned and turned into an efficient cash flow machine, investors will pay more for this asset because of its higher cash flow. A typical value-add strategy consists of the steps shown in the figure below. The sponsor will thoroughly underwrite and acquire the asset, then the specific value-add strategy will be implemented to reposition the asset so it may operate close to its original operational state. The sponsor will work with a third-party management company to bring in tenants at market value and gradually raise rents of the existing tenants. Investors will receive distributions (cash flow) as appropriate from the operations. The property will be stabilized and held in accordance with the exit strategy outlined in the business plan.
In cases of long-term asset holds, the property may be refinanced to extract equity from the forced appreciation and any market appreciation. One of the renowned wealth-building mechanisms is the ability to refinance and allow investors to receive some or all their invested capital back. Also, the refinance is a non-taxable liquidity event because investors are being paid with borrowed money. Investors will continue to receive passive income from the operation of the asset. Eventually, the sale of the asset will occur, and profits will be split between the sponsor and investors. The process will continue again as the sponsor looks to further build wealth by applying the strategy to one or more other properties.
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