WHAT ARE VALUE-ADD INVESTMENTS?
Value add deals are those in which the acquiring investor makes a functional effort to elevate the income stream of the property, typically through a significant capital improvement program such as through a partial or property-wide renovation. Property candidates for value-add opportunities include those which have a cash flow currently in place, however the investor seeks to increase the cash flow over time by improving the property. Investing in value-add properties can generate potential profits in two ways:
(1) Improving the yields and total returns which may be increased by creating additional streams of revenue or increasing the existing income (e.g. by means such as through improving outdated units and increasing rents upon every lease turnover or by adding additional units based on the property's legal zoning possibilities; and
(2) Creating value in the property by investing capital into the property upgrades that will provide the highest level of return by balancing its cost with the potential profit return. The market value of the property will be maximized by investing in a property that promises the highest level of return in proportion to the total amount of capital invested, including acquisition and upgrade costs.
Historic rates of return: 10 to 15%
Risk: moderate to high
WHAT ARE THE CHALLENGES?
Value-add properties may be outdated or rundown and require physical improvements due to neglect or the owner's lacking of capital to make improvements. Value-add properties may also have operational issues due to poor management, high expenses and typically have higher vacancy rates, around 50 to 80 percent leased, than other assets of a comparable size in their respective neighborhood.
These properties have the potential to achieve higher returns after increasing the income with the right kind of physical upgrades, improved management, added services and more effective marketing. They can also be more lucrative after reducing and optimizing expenses. These operational and capital improvements add value beyond routine physical upgrades, and can attract new tenants, improve retention of existing tenants and generate higher rents. When the right value-add property is purchased in the right market, higher returns are realistic with a manageable level of risk. Further, appreciation naturally results which generally provides investors with better options for profitable holding and exit plans.