One of the primary reasons I love commercial real estate so much is the highly inefficient nature of the industry. An inefficient market is one in which an asset’s market prices do not always clearly reflect its true value.
Within the real estate world, this manifests itself in several different ways. For instance: an investor might have owned a property for a number of years, and, due to a myriad of factors, he or she has not kept their leases up-to-date with current market rents. As years progressed, the market rents improved, but the asset’s rent stayed flat. When the owner goes to market to sell the property, the asset’s true value isn’t reflected in the sales price, giving a new investor the opportunity to raise rents, and thus “add-value” to the property’s revenue.
This strategy is just one example of a Value-Add opportunity, my absolute favorite real estate investment strategy.
Value-Add investments are the best of both worlds. They straddle the line between highly speculative “Opportunistic” deals and low-risk, low-return Core and Core Plus investments.
For seasoned operators, Value-Add represents the ideal opportunity to generate large returns and manage downside risk.
Early in my career, my father taught me the strategies of Value-Add investing. Over the years, I became a serious student of the approach, implementing value-add strategies as a principal, consultant, broker and property manager across all asset classes including retail, medical, office, multi-family, and self-storage.
Through my experience, and with the help of some of the greats, including my father, Gregg Beck, Stream Realty’s Michael McVean, Grant Cardone, Westwood Financial’s Steven Fogel, and many others, I’ve refined the following strategy, one that simplifies a sound value-add approach.
The first step in any investment is the acquisition, or put simply, “buy it.”
In order to create a successful value-add investment strategy, the “all in” acquisition cost (purchase price, closing cost, improvements, vacancy loss, etc.), must be well below the future value the asset will have once the plan is implemented.
What does “well below” mean? That depends on your investment goals but for me it is 30%, plus or minus.
That said, in order to buy it right you must have the following, because these cannot be changed:
1. A great location. Super important because you cannot fix a bad location.
2. Be below replacement value.
3. A true opportunity to add value:
i. 20%+ vacancy
ii. Short term leases that can be renewed
iii. Below market rents
After the acquisition comes the fun part, the execution, or, in other words “fix it.”
A value-add property is usually such because something is wrong, so fixing the problem is where value creation really happens. Here are a few examples of what fixing a property can look like:
Upgrade physical plant
1. Upgrade the façade
2. Upgrade or repair building systems such as HVAC, security, etc.
3. Add amenities
4. Improve the parking lot, landscaping, etc.
5. Modernize marketing through websites, social media, etc.
Fix the existing leases
1. Buy out long term, below-market leases
2. Negotiate out of onerous exclusives or restrictions
3. Utilize RSF and USF structures
Once the current property has been “fixed,” it is time to generate new revenues. This is the “Lease it” phase of the investment. As with all investment properties, the asset’s value is typically best reflected by the Net Operating Income, so in order to realize new value, new revenue must be generated.
Here’s a few ideas on how to best deploy a leasing strategy.
1. Provide generous tenant Improvement allowances. For example, assume Provide “free rent” in exchange for term, this benefits the tenant upfront and creates value for you in the future.
2. Aggressive prospecting and market the space – be creative, Many value add opportunities exist in markets where brokers are frankly lazy.
3. Make it easy to lease space, for office and retail, this means compensating tenant brokers quickly and fairly, remember Activity breeds activity
Once the hard work is done, the final stage of the strategy is “Sell it.”
For many investors this is straightforward: they’ve held the property for three, five or seven years, and it is time to go to market and allow a long-term cash flow investor the chance to own a great property.
That said, there are options for what to do next. You can take the proceeds and pay capital gains, alternatively, a tax-deferred 1031 exchange can be another option. This provides an opportunity to delay the payment of taxes and redeploy the proceeds into another investment.
Finally, a third option exists. In this case, the owner doesn’t actually sell the property at all, but capitalizes on the newly created asset value through a refinance.
How does this work? Let’s try a simple example.
Say you purchase an office building for $1,000,000, and you finance it with a 70% loan. Through capital investment, hard work, hustle and a little luck, you raise rents, fill vacancies, and improve the building’s systems. The new value, based on the improved NOI, is $1,500,000.
Now, let’s assume you refinance with a new 70% loan ($1,050,000). After the existing mortgage is paid ($700,000), assuming zero debt was reduced during the hold period, you are left with $350,000! That’s more than your initial investment, and you still own the property and its cash flows!
And, last but not least, there is zero tax on the $350,000 you just received from your lender. Here’s how the math looks:
Original Asset Value $1,000,000
Improved Asset Value: $1,500,000
New Loan (70%): $1,050,000
Current loan Payoff: ($700,000)
Loan Proceeds: $350,000*
* Keep in mind, for simplicity, this example doesn’t include closing cost, but you get the point, you’re smart.
This is a tremendous strategy that can create massive wealth when executed intelligently, and with an eye always on the down side risk.
So, there it is, the Buy It, Fix It, Lease It and Sell It value add strategy. I hope this sheds some light on how so much value is being created in the real estate industry, in absolutely every market, by creative, hard-working real estate entrepreneurs.