046: What is a Value Add Play?

SHOW NOTES FOR EPISODE 046  –  WHAT IS A VALUE ADD PLAY?

In this Fun Facts Friday episode, Bill defines what a “value add play” is and how multifamily real estate investors can implement this strategy for maximum leverage and profit.

If you are a real estate investor, you can just find some nice properties that cash flow well, buy a bunch of them and just collect the rents each month.  If you bought well – meaning a good market with a good demand for rentals — and you can keep the units rented, well-managed and have an adequate budget to maintain the properties, you will likely see that property cash flow for a while. Your main focus is cash flow or monthly income.  And that’s it.  Classic “buy ‘n hold.”

Then, there’s a more strategic approach.  It involves buying properties that are also in a good market with good demand – and you have the intention of making good cash flow as well – But, in addition to cash flow, your goal is to see it appreciate in value and to sell it at a significant profit and to use that money to buy a bigger property or multiple properties and then do the same.  Rinse and repeat.

And who’s to say which way is better.

If you’ve listen to the Old Dawg’s REI Network, you know that I’ve had lots of guests on the show who have talked about how they bought, for example, a 200 unit apartment for like $3 million, did a value-add play and in 2-3 year, double it’s cash flow and sell it for a cool for $9 million.

True stories.  People do it all the time.  Maybe not to that extremes all the time but it is a popular strategy being used by a lot of multifamily real estate investors today.  It’s called a value-add play.

Value Add Play Defined

Value Add Commercial Real Estate Investments typically target properties that have in-place cash flow, but seek to increase that cash flow over time by making improvements to OR by repositioning the property.

This could include making physical improvements to the asset that will allow it to command higher rents, increasing efforts to lease vacant space at the property to quality tenants, or improving the management of the property and thereby increasing customer satisfaction or lowering operating expenses where possible.

Once the operator has successfully increased the net operating income at the property, they typically seek to sell the asset to capture the resulting appreciation in value.

These operators often employ the use of medium to high leverage to finance their projects and increase returns to themselves and their investors.  Successful value add projects will typically generate higher financial returns to investors than core investments due to the appreciation in value, however these projects bear more risk due to the fact that at the time of acquisition, the property is not operating at its full potential—often times because it is not fully leased, is leased at below market rents, has not been properly maintained or is poorly managed.  If the operator does not execute their proposed business plan, they can fail to meet their projections and could be forced to sell the property at a lower price than expected.

For many investors, however, value add projects provide the perfect balance of risk vs. return—offering in-place cash flow at the time of acquisition with significant upside potential in the form of value appreciation.

The formula is simple:  If you can increase cash flow and reduce expenses, you will increase profit and the overall value of the asset

Value add is not to be confused with a major construction play where you need to gut the property down to 2x4s and almost rebuild from scratch.  The rehab/upgrades are generally simple improvements.  The idea is keep a lower capital investment that will be recouped in a relatively short period of time.

So why am I even talking about this?

Because I believe this is one of the key advantages of investing in multifamily properties!  You can’t do this with a single family residence (SFR).  Sure, with an SFR you can do a fix ‘n flip move by taking a junky house, fixing it up and renting or selling it at market prices, but, with multifamily, you can do things to your property to make it worth MORE THAN MARKET.  That’s right!  You can control the value because you are looking at as a business asset – not just a piece of property that is subject to market comps.

I is a viable strategy that you should consider.  And for me, it’s a smart short term methodology that I believe can help me, through leveraging value add properties, to achieve  my goal of 1,000 units by 2020 — especially since that goal depends on me doubling the number of units I have each year.

So what does a value add play look like?

• First you need to find an underpriced property. Why?  Because you can have “instant equity” upon closing of escrow – moving you one step closer to your end goal
• It needs to be in an asset in a strong and/or growing market
• Needs to be in a good rental market where there is a steady demand for rentals like what you are offering
• Rents for the asset should be under-market – Can you increase rents? When? How much?

There should be physical improvements you can make that will increase tenant value, help generate increased rents and directly contribute to increased cash flow and short/long term equity growth.

Some of the physical improvements may include:

• Upgrade exterior (curb appeal – painting, landscaping, entrance, signage, parking lot, pool area, adding a dog run/park, barbeque areas, play area, etc.),
• Interior common areas – hallways, laundry, community rooms, work-out room
• Units (paint, windows, floors, kitchen countertops, bathrooms, appliances)

Carefully budget for these items because you want to recoup the investment you put into you value add improvements in a short period of time.  Don’t go into a “C Class” area and put in “A class” upgrades (granite countertops, all stainless steel appliances, etc)  The increased cash flow should cover help recover your intial investment fairly quickly

Besides, physical improvements, you can reduce expenses.  This will increase cash flow as well.

Some expense reductions include:

• Restructure loans
  • Re-fi or negotiate better interest rate
  • Do interest only payments for a year to boost cash flow – use funds to finance other improvements
• Reduce “owner funded” expenses
  • Water conservation efforts
    • Low-flush toilets
    • Faucets
    • Can hire firms to do complete analysis and come back with a plan
  • Electrical
    • Re-wiring (we provided gas stoves – gas is paid by owner) rewired to all units to 220 and switched to electric stoves
    • LED bulbs
    • Sensor lighting, timers
  • Heating
    • We went from boiler-based heating to floorboard heating in each unit – by upgrading electrical in each unit so that tenants take on heating expense
  • Challenge property tax assessments
  • Find less expensive insurance
  • Renegotiate or hire new service providers
    • Lawn service
    • Pest control
    • Pool service
    • Security

I mentioned repositioning and perhaps that warrants another podcast but I mention it only  because value-add is often confused with repositioning or they are often mentioned together.

What about Repositioning?

• Repositioning often involves more the transformation of an asset into a different type of asset. For example, taking an asset from a …
  • weekly-rental mens’ motel into student housing
  • section 8/low income housing to senior housing
• It can occur with a value add play but not always
• Sometimes these terms are used interchangeably but the terms have different meanings
• Repositioning is more complicated than just raising rents and doing a few improvements.  It involves a targeted effort to replace the current tenant base with a completely different type of tenant that you have research and feel confident will move into your asset
  • Easier done with a 100% vacant asset
  • Major challenge to have both tenant levels at same property during transition

Does a value add always work?  Not necessarily.

• You MUST know your market. The market must be right? And the property must be right
• So how do you know if the market is right and the property is right?
  • You need to research/study your market well
  • Get advice from an experienced mentor who hopefully knows your market and who has done this before

Well, that’s it.

So, until next time, remember CASH FLOW IS KING AND REAL ESTATE INVESTING THE MEANS.  Thanks again for listening and God bless!

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