Value-Add Real Estate Investing: What Does It Really Mean and Is It Risky?

In real estate, thorough due diligence identifies opportunities that bring value to a real estate asset. This means creating additional revenue and overall value through various methods. Here are a few examples:

  • Increased rents
  • Cutting unnecessary expenses
  • Improving energy efficiency
  • Adding or repositioning square footage
  • Cosmetic updates
  • Offering amenities
  • Separately metering utilities to bill back to tenants
  • Improving the brand  

Now that we understand ways you can value-add, let’s discuss how this strategy can apply to an individual asset.  The key is detailed, accurate due diligence. There’s wisdom in the old saying, “Garbage in, garbage out” — because that’s what you’ll end up with if you rush this process.

Each transaction has numerous data points and financials to carefully evaluate and test. That includes looking for variances and discrepancies in the market, property, leases and expense patterns.

For a closer look at this process, let’s explore a hypothetical example that involves rents.

Evaluating the Value of Amenities

Imagine you’ve found a property that’s renting at $1.65 per square foot, while similar unit sizes and configurations in other nearby buildings are renting at $1.89 per square foot. This shows potential for value-add opportunity, but you can’t decide anything without more detailed information.

The First Step:  Study the amenities and condition of the comparable units.  This requires touring some of the property comps and conducting online research to understand how other properties match up to yours. For example, you might discover that if you upgrade countertops and appliances, you would be exactly on par with the competition. These improvements should allow you to achieve the $1.89 per square foot objective. But is this really a value-add opportunity? Let’s consider a few calculations that can help us decide.

Cost vs. Increased Revenue

After you identify aspects of the asset that could improve revenue or reduce expenses, you must quantify what that really means. Here’s the question you need to answer: What is the cost/investment to create the improvement, and what excess revenue or value does it provide? 

To show how this works with our hypothetical property example, let’s consider the addition of granite counters and stainless-steel appliances. Assume that the cost to implement these changes in bulk would be $2,400 a unit. Next, we need to understand how to evaluate whether the return on these investments is worthwhile.   

In this example, we know that these improvements will warrant an extra $0.24 per square foot in rent. Let’s assume we have 75 units and a blended 750 square feet per unit. Take the $0.24 in unit cost and multiply that by 750 square feet. This equals an additional $180 per month in rent.

But we don’t have just one unit, we have 75. That means an increased revenue of $13,500 monthly and $162,000 annually. 

Consider the Cap Rate

These numbers are impressive. But if we’re going to make an informed investment, we need to know how it affects the overall value of the building.   

Real estate assets trade off a cap rate, which is net operating income before debt service. The lower the rate, the more the asset is worth in value.  For our example, let’s use a 5% cap rate.  Note that understanding market cap rates for the type of asset you are underwriting is important to size this correctly. 

If the asset is now generating additional revenue of $162,000 a year, you would divide that number by the cap rate of 5%. This gives you a $3,240,000 increase. You must then subtract the cost of the improvements — $180,000 in this case (75 units x $2,400). With these calculations, the net profit from the $180,000 investment would equal $3,060,000. See the table below for further clarification.

Impact of minor rental increase
No Shortcuts for Successful Investment Decisions

Value-add opportunities will always exist in the market. Those who can identify and underwrite properly will reap the benefits.  This strategy can be very lucrative and is independent of market appreciation.

However, each value-add investment will not be as lucrative as the hypothetical example we’ve outlined here. That’s why it’s critical to spend the time verifying the data you will use to make your decisions. A poorly underwritten or executed value-add plan can swing in the other direction and be costly to the owner or operator.   

At Lucern Capital, we appreciate the importance of careful analysis. Our team has successfully executed on over $2.5 billion of debt and equity transactions through our careers. Unlike our competitors who prefer risky, short-sighted investments in the next “hot” location, we focus on long-term sustainable cash flow. Our team concentrates on under-market, mismanaged, and distressed assets at an attractive comparable basis. Because our strategy centers on the value-add approach, the opportunities we uncover continue to generate superior risk-adjusted returns for investors.

Ready to invest with a team that has the necessary value-add expertise to produce superior returns? Contact us today.