Countless commercial real estate investing strategies exist. One of the more popular strategies is called “value add.” While experienced investors use this phrase frequently, it often confuses novices: is this strategy as straightforward as it seems, and how does an investor actually add value to a property? As such, we’ll use this article to explain what a value-add real estate deal means.
Specifically, we’ll cover the following topics:
- Determining Value in Commercial Real Estate
- Value-Add Real Estate Deals
- Final Thoughts
Determining Value in Commercial Real Estate
Before adding value, investors need to understand how to determine value. In residential real estate, appraisers use the sales of comparable properties – “comps” – in the market to determine the value of your home. This approach works due to the relative uniformity of these homes and volume of sales.
In commercial real estate, this same uniformity and sales volume does not exist. A neighborhood may include a large, mixed-use building (e.g. a couple retail spaces at ground level and 12 apartments in the top floors). Using the comps approach, appraisers would need to find a nearly identical property in close proximity that recently sold – highly unlikely.
As a result, investors and appraisers have developed a different approach to valuing commercial real estate. Rather than rely on sales comps, commercial real estate value depends on the income produced by the property and an associated market metric. More precisely, parties use a mathematical formula – the commercial value formula – to determine value. According to this formula:
Property Value = NOI / Cap Rate
NOI, or net operating income, equals a property’s rental revenue minus all operating expenses (NOTE: mortgage interest and depreciation are not operating expenses). Due to NOI’s role in the commercial value formula, this valuation technique is commonly referred to as the income approach.
Conceptually, capitalization, or cap, rate equals the return a property would generate on an all-cash (i.e. unleveraged) deal. For instance, if you bought an apartment building for $1,000,000 cash and it generated operating income of $50,000, it would have a 5% cap rate. Mathematically:
Cap Rate = NOI / Property Value
As this rearranged formula illustrates, cap rates depend upon two interrelated factors: a property’s operating income and its value. More precisely, cap rate hinges on a property’s risk and stability. If a property generates stable, reliable income, investors will pay a premium, which increases value and creates a lower cap rate. Conversely, unreliable income creates more risk for investors, lowering the property’s value and increasing its cap rate. Practically speaking, cap rates are dictated by the local market, the property type, and the tenants.
Value-Add Real Estate Deals
What is Value-add Real Estate?
Value-add investors attempt to use this commercial value formula to their advantage. In simple terms, value-add real estate deals take existing properties and make some sort of improvements to A) increase NOI, B) decrease the cap rate, or C) both. In doing so, the value of the property increases.
Let’s use the above $1,000,000 property as an example. When you purchase the property, it generates $50,000 in NOI, translating to a 5% cap rate. As new owners, you change the management company and make some common area improvements. These updates lead to increased rents and decreased operating costs, both of which translate to a new NOI of $60,000.
Assuming the same cap rate, that $10,000 increase in NOI leads to a $200,000 increase in the property’s value ($60,000 / 5% = $1,200,000). Value-add investors can then realize this increased value by selling the property or pulling some cash out in a refinance.
A variety of value-add techniques exist to take advantage of the commercial value formula. Below, we’ve outlined three of the more common ones.
Value-add Technique 1: Increase Rents
Returning to the commercial value formula, two ways exist mathematically to increase value: increase the numerator (NOI) or decrease the denominator (cap rate). If you can increase rents while keeping operating expenses stable, you increase the property’s NOI and, by extension, value.
To accomplish this, many value-add investors pour money into aesthetic improvements. For example, repainting a building, improving landscaping, and re-flooring common areas are all ways to improve the look and feel of a property. And, this improvement can justify charging hire rents.
Furthermore, some investors will also completely renovate units. If you replace 80s- or 90s-era furnishings and appliances with modern ones, you will command hire rents. While these renovations cost money, a well-analyzed deal will lead to the associated increase in value justifying the renovation cost outlay.
Value-add Technique 2: Decrease Operating Expenses
In addition to increasing rents, many value-add investors look to boost NOI by decreasing a property’s operating expenses. If it costs less to operate a property, the NOI will increase, and the value will increase (NOTE: aggressively cutting costs to the detriment of tenant satisfaction will likely have the opposite effect, so take care to find an appropriate balance when looking for efficiencies).
Many value-add investors replace existing property management companies when they purchase a building. If you can streamline and, where possible, automate management processes, this expense should decrease. Or, if you include utilities in rent, installing usage monitoring devices can help you catch spikes (e.g. due to a running toilet) in real time – not when you receive a massive utility bill.
Regardless of technique, decreasing a property’s operating expenses (assuming you concurrently maintain or increase rents) will increase a property’s value.
Value-add Technique 3: Increase Stability / Lower the Cap Rate
The above two techniques focused on the numerator of the value formula. Here, value-add investors focus on decreasing the denominator – cap rate. While the market largely drives local cap rates, investors can take some steps to lower it.
Traditionally, Class A multifamily properties have less risk and more stability than Class B or Class C properties. As such, these nicer buildings generally command lower cap rates – and higher valuations. If a value-add investor’s renovations can bump a property up a property quality class, an associated decrease in cap rate should follow.
Related, reducing tenant turnover increases a property’s stability and decreases risk, also leading to a lower cap rate. If landlords take measures to reduce turnover (e.g. imposing credit checks and income minimums to screening, incentivizing multi-year leases, etc.), a building’s stability increases and cap rate should decrease.
Value-add investing certainly isn’t the only commercial real estate strategy, but it is one of the more popular – and effective. Accordingly, having a solid understanding of this strategy will help new investors analyze potential deals.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available value-add real estate investment opportunities.