Fundamentals of Value-Add Real Estate Investing
Why Investors Choose Value Add
Among commercial real estate investment strategies, value-add real estate investing has historically offered some of the highest potential for returns on your initial capital; its track record has framed it as an attractive option for commercial real estate (CRE) investors. However, executing this investment strategy requires plentiful research and background understanding of the factors in play.
In this article, you will learn the fundamentals of value-add real estate investing and how to employ this strategy in your portfolio. Additionally, this article covers alternatives such as core plus investing to address all risk preferences and investment goals. Read on to learn more.
What is Value-Add Real Estate?
Also known as value-oriented real estate, value-add real estate is any commercial property with existing income but significant opportunities for improvement via operational enhancements, market repositioning or redevelopment. In other words, value-add properties are those that have some income but are not yet at their maximum income potential.
The basic strategy behind value-add real estate investments is to increase the income of a property while the total value of the property appreciates simultaneously.
Because value-add real estate generates income, it has significant opportunity for improvements. It presents a moderate-risk approach for CRE investors who are looking for stable income and capital appreciation. When you invest in the right properties, value-add real estate has the potential to provide durable in-place income.
Alternatives to Value-Add Real Estate
Investing in value-add real estate is a solid strategy for many investors, but it is not the only strategy. Other commercial real estate investment strategies you may find suitable could include one or more of the following approaches:
1. Core investing
2. Core-plus investing
3. Opportunistic investing
Each of these strategies offers a different level of risk and requires a different amount of capital and accreditation. Location, the condition and age of the property and the tenant mix can all affect which category of investment a commercial property fits into.
A “core” real estate investment is the purchase of a property that is likely to generate stable long-term income. These properties are well-kept and already occupied by long-term tenants, typically on multi-decade leases.
The strategy behind investing in core properties is much like the strategy behind investing in bonds. While the returns are not guaranteed, they are extremely predictable and require very little active management on the part of the investor.
Here are some of the pros and cons of core real estate investing:
- Pro: The risk level involved in this type of investment is lower.
- Pro: These properties require almost no active management or improvement.
- Pro: These properties provide stable income to potentially support riskier investments elsewhere in your portfolio.
- Con: The ROI potential is lower overall.
- Con: Appreciation is usually limited for core properties.
As you can see, core investing and value-add investing are similar, but they are far from the same thing. They both involve the acquisition of income-generating assets, but the risk and potential for appreciation are much lower for core properties. In fact, core property investing is often considered a particularly low-risk investment.
A “core plus” real estate investment is the acquisition of a property that is generating relatively stable income but in need of some light repairs or renovations. Core plus properties can be more than a decade old in many cases, and the income they generate may be slightly offset by the cost of future repairs.
The strategy behind core plus investing is similar to that of core investing: Invest in properties that are in relatively good condition and generate relatively stable income. The key difference is that the risk is slightly higher, more active management is required and the potential for appreciation is higher — all thanks to the added room for improvements made to core plus properties.
Here are some of the pros and cons of core plus real estate investing:
- Pro: These properties generate relatively stable income.
- Pro: Core plus properties offer some room for appreciation.
- Con: Some cash flow may need to be reserved for improvements.
- Con: Slightly distressed property conditions add more risk to the equation than core properties.
If you are learning about value-add real estate investing, core plus properties present only a limited amount of risk — thanks in large part to the property conditions that are somewhat more in need of attention.
The upside of the added risk, of course, is that there is room for higher ROI in terms of appreciation and, once improvements are complete, cash flow.
The name of “opportunistic” real estate investments is fitting because these investments are all about opportunity. These properties are usually in bad condition with little or no cash flow. They may require total renovation and/or repositioning to generate reliable income. While the initial investment is among the riskiest you can make in CRE investing, the potential for return can also be the highest.
The strategy behind opportunistic real estate investing is one that is best executed by working with a team of trusted advisors. The idea, of course, is to significantly improve these properties and generate returns.
Here are some of the pros and cons of opportunistic real estate investments:
- Pro: These investments present high ROI potential.
- Pro: Competition to acquire these properties is often much lower leaving greater room for sales negotiations..
- Con: Returns can be delayed for years or more as improvements are made.
- Con: Unforeseen obstacles and conditions can limit or completely prevent appreciation or reliable cash flow.
Opportunistic real estate is considered a higher-risk investment. While the idea of improving the property and benefitting from both appreciation and potential cash flow is one shared with value-add real estate investing, the two strategies differ significantly in their level of risk. Value-add real estate is considered a more moderate-risk investment than opportunistic but higher risk than core and core plus.
Now that we’ve covered alternative CRE investment strategies to value-add investing, let’s discuss why value-adds’ investment potential for income and meaningful growth while still balancing risk and reward is a great middle ground.
Now, taking a closer look at strategies within the field of value-add real estate investing, here are three common strategies to consider:
- Operational value investing
- Renovation or physical value investing
- Location or reposition value investing
1. Operational Value
The operational value strategy involves investing in CRE — whether through individual properties or a portfolio — that may derive and provide value from improvements in operations.
Improvements in operations can take many forms, but one readily available example can be found in improvements for energy efficiency. For example, replacing traditional light bulbs with LED lights can save thousands of dollars in operational costs, making the property more efficient.
2. Renovation or Physical Value
When you invest in a commercial property or portfolio that presents the potential for appreciation via renovations or similar physical improvements, you are participating in a renovation or physical value value-add investment strategy.
For example, if you purchase an office building that has little in the way of common areas, gyms, dining options and similar amenities, you can add value by adding these features to increase occupancy. That, in turn, creates the potential to increase cash flow.
3. Location or Reposition Value
The location or reposition value strategy is a method of value-add investing that relies on properties’ physical locations or potential to change functions. ROI depends on the inherent value of a prime location or the value added by repositioning a building to occupy a more valuable function.
For instance, you might add significant value by converting a low-traffic retail center into a high-occupancy office park. Alternatively, you might derive value from purchasing an empty or low-occupancy property that is located in an area that is quickly developing or undergoing gentrification.
General Risks When Considering CRE Investing
While value-add investing can be a solid investment, it does come with some risks. However, these risks are inherent in almost all kinds of CRE investing — not just value-add. Nonetheless, these are some of the risks to consider when you are considering an investment:
- A decrease in demand for office or retail space may have a material adverse effect on financial conditions and results of operations.
- Economic and regulatory changes that impact the real estate market generally may decrease the value of investments and weaken operating results.
- Global and U.S. market, political and economic conditions may adversely affect liquidity and financial conditions and those of tenants.
- Market trends and other conditions outside of the control of the property owner could decrease the value of investments and weaken operating results.
- Property owners are subject to governmental regulations that may affect the renovations to, and use of, their properties.
- Properties that have significant vacancies could be difficult to sell, which could diminish the return on your investment.
- Real estate assets are illiquid, and owners may not be able to sell their properties when they desire.
- Property owners may be limited in their ability to diversify investments, making them more vulnerable economically than if their investments were diversified.
How Does Value-Add ROI Work?
There is no doubt that value-add CRE investing presents some risks, which we have outlined in detail above, but there is also the potential reward to consider. The opportunity to re-lease, reposition, redevelop and otherwise improve these properties presents an expansive potential for ROI.
Particularly, when executed correctly, value-add investment strategies present opportunity for income growth through improvements, capital appreciation and, ultimately, increased cash flow and/or dividend payouts to investors.