Everyone understands that when you fix something up, generally speaking, you increase its value. When you apply this to private equity real estate, this is called value-add investing.
In business, value-add refers to the extra features a company gives its products that go beyond standard expectations, such as free maintenance, training or warranties. These features can give goods and services a competitive edge that lets companies charge more for them — and inspires customers to pay those higher costs.
In private equity real estate investments, value-add goes beyond product differentiation. Fund managers spend money to make physical or operational improvements that enhance a property’s value. To succeed at this strategy, it is critical that fund managers have a solid understanding of a property’s physical condition, competitive position within the market, cash flow and leasing prospects, as well as what risks and rewards improvements may have on the overall investment performance. There are hundreds of variables that go into consideration when underwriting a value-add real estate property to help make this decision.
Investors evaluating a value-add opportunity must consider the level of risk they’re willing to take to receive returns that achieve their investment goals. Generally, value-add investors are willing to take on more risk to achieve high returns and are willing to wait longer before they begin receiving returns for their investment. Nearly all of the value-add investor’s return will come in the form of appreciation, with no expectation of cash flow for at least 24-36 months. On the risk vs. return spectrum, value-add real estate holds a middle ground between the less risky (core or core-plus) and more risky (opportunistic) investment strategies.
Value-add properties may be outdated or rundown and require physical improvements due to neglect or owners lacking the capital to make improvements. Value-add properties may also have operational issues due to poor management and typically have a higher vacancy rate – around 50 to 80 percent leased – than other assets of a similar size in their neighborhood.
These properties have the potential to achieve higher returns after increasing income with the right kind of physical upgrades, better management, added services or more effective marketing. They can also be more lucrative after reducing and optimizing expenses. These operational and capital improvements add value beyond routine physical upgrades, and can attract new tenants, improve retention of existing tenants and generate higher rents from both segments. Once improvements have been made to the property, increasing its net operating income, a value-add property is typically then considered a less risky investment and sold to another buyer looking for a lower risk strategy.
How Do Investors Find Quality Value-Add Deals?
Value-add investors, if they have deep market knowledge and the ability to execute business plans, can build their own portfolio of individual real estate deals through the open real estate market. Or they can outsource this process by investing through a fund manager or crowdfunding website. There are pros and cons to each option.
Investors who choose Origin as their fund manager benefit from our real estate professionals who live and work in their target markets to source the best deals. We’ve learned that its critical to have associates with first-hand knowledge of each city who form relationships with local real estate brokers, so that we can have access to the best opportunities. We find properties with trapped value — either physically, operationally or structurally. A structural trap can be from a debt standpoint or related to partnership issues within the existing ownership. Once we identify the property, we create a business plan to maximize value and then we settle on the right price based on the cost, risk and timing of our turnaround plan.
From there, it’s critical we find the best property management firm to execute the business plan. One of our most compelling value propositions as a fund manager is that we focus solely on asset management and hire the best third-party service providers to help carry out our business plan. We hire partners based on the specific business plan needs, property type and market or sub-market. Fund managers who also provide property management, project management and construction management services may run into issues where it’s very difficult to fire themselves if they aren’t performing. We are structured by design to avoid this conflict.
We also have flexible investment capital. Financing needs often change in the course of a value-add project. A firm with multiple funding sources adds value by reacting quickly, putting in place the right financing structure to meet the needs of the business plan and even injecting funds to keep a schedule on track. For instance, we have and can inject new capital to pay off debt, which gives us time to put in place a new value-add program to maximize revenue.