Why Value Add Apartments Add Great Value to Your Portfolio
What if you could have an investment that paid you cash flow from day one (or close to it), increased in value with some strategic planning, and then on top of that cash flow, gave you a nice, big lump sum at the end? With the stock market, we invest our money but never enjoy any of the proceeds until we sell (or wallow in the losses), unless of course, you are dividend investing. I like apartment investing because I have that cashflow to help out with my monthly personal expenses, but I know I am still adding to my nest egg with the "value" that I am "adding" through the apartment's improvements.
If you are new to real estate, you may not know the term "Value Add," but in some way, shape, or form, you know the philosophy behind it. Maybe you fixed up an old bike, sold it, or repurposed an old piece of furniture that turned it into a new piece of furniture and suddenly increased its value.
You have most definitely noticed all the house flipping shows on tv, where they take the tired, outdated home, tear the guts out, update and put it back on the market for a substantial profit. The difference here is these flips do not pay you cash flow and pay a heavy short-term tax burden.
That is why apartment value add investing is the best of both worlds. It pays you cash flow, protects you from taxes through cost segregation and bonus depreciation, and then still has the pot of gold waiting at the end when it is time to sell or refinance.
The Basics of Value-Add Real Estate
Value-add multifamily real estate deals follow a similar model to house flipping but on a massive scale. Hundreds of units get renovated over the 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A great value-add property may have peeling paint, outdated appliances, or overgrown landscaping, which all affect the curb appeal and the initial impression that a potential renter will form.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)
Common value-add renovations can include individual unit upgrades, such as:
● Fresh paint
● New cabinets
● New countertops
● New appliances
● New flooring
● Upgraded fixtures
Besides, adding value to exteriors and shared spaces often helps to increase the sense of community:
● Fresh paint on building exteriors
● New signage
● Dog parks
● Covered parking
● Shared spaces (BBQ pit, picnic area, etc.)
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. Still, 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 live 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 happier 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 projects need to account for a temporary increase in vacancy rates due to turnover and new leases.
Why Is Investing in Value-Add Properties so Beneficial?
When done well, value-add strategies benefit all parties involved. We provide tenants a more aesthetically pleasing property through renovations, with updated appliances and more attractive community space. We also improve the safety, security, and overall community-feel of the property. By doing so, the property becomes more valuable, allowing higher rental rates and increased equity, which makes investors happy too.
The property-upgrade 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.
Stabilized Yield Play
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 potential future profits. Yield play investments are where a currently-cash-flowing-property that's in good shape is purchased and held in hopes to sell it for profit, without doing much to improve it. 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. In a yield play, everything is dependent upon the market appreciation.
In a value-add investment, significant work (i.e., renovations) increases the property's value and makes such improvements carry a significant risk level. However, value-add deals also come with a ton of potential upside. Through physical action steps that improve the property and increase its value, value-add investors "force" the appreciation.
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 then in a yield play.
Of course, a hybrid yield + value-add investment is ideal. This is where an asset gets improved as the market increases simultaneously. Investors have control over the value-add renovation portion, and the market growth adds appreciation.
Before I come off like a used-car salesman, let me offer a disclaimer: No risk, no reward. We reap financial rewards due to the risk we take on by taking on these under-appreciated apartments.
This video quickly goes through three different apartment investing strategies.
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)
When evaluating deals as potential investments, look for sponsors who have capital preservation at the forefront of the plan and who have several risk mitigation strategies in place. These may include:
● Conservative underwriting (This is what I preach!).
● 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 risks. This is why risk mitigation strategies are important - to protect investor capital at all costs.
Recap and Takeaways
No investment is risk-free. However, despite its risks, when something provides great benefits to the community AND investors, it becomes quite attractive.
Properly leveraging investor capital in a value-added 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.
Cash flow, tax benefits, capital appreciation, all while improving communities? Sign me up.