Using Commercial Value-Add Real Estate Syndications to Increase Cash Flow and Appreciation

by | Jul 9, 2022 | Investing Advice | 0 comments

We love the beach and it plays a big part in our story. Michael grew up there, and we were engaged there.

Imagine that we’re walking down the beach and spot a broken surfboard that is clearly unwanted. We decide to turn it into a creative project, so we take the board home. After putting in some time and elbow grease, we turn that old, abandoned surfboard into a unique work of art.

We proudly hang the new artwork in our home. A few years later, someone sees the piece and has to have it. We end up selling that previously damaged surfboard for more than twice the amount of the money we put into it. 

In this scenario, we took something that had been overlooked, committed some sweat equity, and transformed it into something more valuable and longer-lasting than it was before. 

This is the essence of value-add, and it’s a commonly used strategy in real estate investing. 

 

The Basic Concept of Value-Add Real Estate

In the case of single-family homes, the process of buying a run-down property, remodeling it, and then selling it for profit, is commonly referred to as fix-and-flip. Your sweat equity and ability to see a diamond in the rough is rewarded monetarily, and the new owner gets an updated, move-in-ready home. 

Value-add multifamily real estate deals follow a similar model, but on a massive scale. Hundreds of units get renovated over years at a time instead of just one single-family home over a few months. 

A great value-add property may have peeling paint, outdated appliances, or overgrown landscaping, which all affect the curb appeal and the initial impression that a potential renter will form. Simple, cosmetic upgrades can attract more qualified renters and increase the income the property produces. 

In value-add properties, improvements have two goals:

  1. To improve the unit and the community (positively impact tenants)
  2. To increase the bottom line (positively impact the investors)

 

Examples of Value-Add Real Estate

Common value-add renovations can include individual unit upgrades, such as:

  • Fresh paint
  • New cabinets
  • New countertops
  • New appliances
  • New flooring
  • Upgraded fixtures

 

In addition, adding value to exteriors and shared spaces often helps to increase the sense of community:

  • Fresh paint on building exteriors
  • New signage
  • Landscaping
  • Dog parks
  • Gyms
  • Pools
  • Clubhouse
  • Playgrounds
  • Covered parking
  • Shared spaces (BBQ pit, picnic area, etc.)

 

On top of all that, adding value can also take the form of increasing efficiencies:

  • Green initiatives to decrease utility costs
  • Shared cable and internet
  • Reducing expenses

 

The Logistics of a Multifamily Value-Add

The basic fix-and-flip of single-family homes is pretty familiar to most people, but when it comes to hundreds of units at once, the renovation schedule and logistics aren’t as intuitive. Questions arise around how to renovate property while people are living there and how many units can be improved at a time. 

When renovating a multifamily property, the vacant units are first. In a 100-unit complex, a 5% vacancy rate means there are five empty units, which is where renovations will begin. 

Once those five units are complete and as each existing tenant’s lease comes due for renewal, they are offered the opportunity to move into a freshly renovated unit.  Usually, tenants are more than happy with the upgraded space and happy to pay a little extra. 

Once tenants vacate their old units, renovations ensue, and the process continues to repeat until most or all of the units have been updated. 

During this process, some tenants do move away, and it’s important for projects to account for a temporary increase in vacancy rates due to turnover and new leases.

 

Why We Love Investing in Value-Add Properties

 

When done well, value-add strategies benefit all parties involved. Through renovations, we provide tenants with a more aesthetically pleasing property, with updated appliances and a more attractive community space. By doing so, the property becomes more valuable, allowing higher rental rates and increased equity, which makes investors happy too. 

The property-beautification process and the fact that renovated property is more attractive to tenants is probably straightforward. But let’s dive into why value-add investing is a great strategy for investors.

 

Let’s Discuss Yield Plays

To fully appreciate value-add investments, we must first understand their counterparts, yield plays. In a yield play, investors buy a stabilized asset and hold it for the monthly cash flow and potential future profits. 

Yield play investments are where a currently cash-flowing property that’s in decent shape is purchased.  The property provides a recurring stream of income from the rents collected – the yield.  There is obviously a hope to sell it at some later date for a small profit, but there is no business plan to renovate, force appreciation, improve the asset and realize a larger gain at sale. Yield play investors hold property in anticipation of potential market increases, but there’s always the chance of experiencing a flat or down market instead. 

 

Now, Back to Value-Adds

Value plays and yield plays are different. In a value-add investment, significant work (i.e., renovations) takes place to increase the value of the property, and doing such improvements carry a level of risk. 

However, value-add deals also come with a ton of potential upside since the investors hold all the cards. Through physical action steps that improve the property and increase its value, value-add investors don’t just hold the asset hoping for market increases, they force increases through improving the asset, raising rents, and lowering expenses. 

Through property improvements, income is increased, thus also increasing the equity in the deal (remember, commercial properties are valued based on how much income they generate, not on comps, like single-family homes), which allows investors much more control over the investment than in a yield play. 

Of course, a hybrid yield + value-add investment is ideal. This is where an asset gets improved, cash on cash yields are high and the market increases simultaneously. Investors have control over the value-add renovation portion and the market growth adds appreciation. 

Now, before you get too giddy about the potential of a hybrid investment, there are risks associated with any value-add deal. 

 

Examples of Risk in Value-Add Investments

In multifamily value-add investments, common risks include:

  • Not being able to achieve target rents
  • More tenants moving out than expected
  • Renovations running behind schedule
  • Renovation costs exceeding initial estimates (which can be a big deal when you’re renovating hundreds of units)

 

These risks are significant, which is why having a solid team with experience is important. Experienced team members can often do better up-front assessments of how much a renovation will cost or how long it will take. 

However, very few can predict sudden turns in the market, supply chain shortages, or massive increases in lumber costs and other materials. That means your syndication team needs to have a solid risk mitigation system in place. 

 

Risk Mitigation

When evaluating deals as potential investments, look for sponsors who have capital preservation at the forefront of the plan and who have a number of risk mitigation strategies in place. These may include: 

  • Conservative underwriting
  • Proven business model (e.g., some units have already been upgraded and are achieving rent increases)
  • Experienced team, particularly the project management team
  • Multiple exit strategies
  • The budget for renovations and capital expenditures is raised upfront, rather than through cash flow

Value-add investments can be powerful vehicles of wealth, but they also come with serious risks. This is why risk mitigation strategies are important – to protect investor capital at all costs.

 

Value-Add Real Estate Investments Have Strong Growth Potential

No investment is risk-free. However, when something, despite its risks, provides great benefits to the community AND investors, it becomes quite attractive. 

Properly leveraging investor capital in a value-add investment allows drastic improvements in apartment communities, thereby creating cleaner, safer places to live and making tenants happier. 

Because investors have control over how and when renovations are executed, rather than relying solely on market appreciation, they have more options when it comes to safeguarding capital and maximizing returns. 

If you have a team with a solid risk management system in place and a clear vision for value-add real estate investments, you can approach the risks boldly as part of your plan to live a life of freedom and financial independence.

Related Passive Real Estate Investing Explained

0 Comments

Submit a Comment

Your email address will not be published. Required fields are marked *