If you are relatively new to real estate investing, you may have seen and heard the term “value add” but were not 100% sure what it means. You can learn about it below.
What is a value add real estate deal?
Every real estate transaction has a value creation strategy associated with it. Value add deals are those in which the transaction’s sponsor makes an active effort to elevate the income stream of the property, typically through a significant capital improvement program such as a partial or property-wide renovation.
The different types of real estate strategies
If you think of risk as a spectrum, where on the left end is the least risky deal type and on the right end is the most risky deal type, from left-to-right, deal types would be ordered as follows:
- core – strategy: ride the rising rent tide
- Example: acquisition of a stabilized class A apartment building in a tier 1 market
- core-plus – strategy: increase property occupancy to stabilization
- Example: acquisition of a class B office building with 15% vacancy
- value add – strategy: improve the product to command higher rents, possibly expanding the square footage as well
- Example: acquisition and unit by unit renovation of an existing tenanted apartment building
- Example: acquisition of an existing tenanted office buiding, lobby renovation and addition of one or more floors, along with re-skinning of the exterior
- opportunistic – strategy: provide new supply to satisfy growing demand
- Example: ground-up development of a retail plaza in a newly-developed suburban community.
What are the unique risks of value add deals?
While all real estate investments involve risk, value add deals can involve the following unique risks:
- construction schedule and cost overruns – as the saying goes, you don’t know what’s in the walls until you tear them open… there could be some unpleasant surprises lurking like friable asbestos that requires full abatement
- terminating an existing cash flow stream – if you are renovating an apartment building’s units, you are deliberately incurring an additional, special type of vacancy tied to the renovation activity. Any time you turn off a cash flow stream, you run the risk of not being able to turn it back on as quickly or at the desired level.
- incurring deficits by moving too fast – if you are funding apartment unit renovations from operating cash flow, you need to be careful to not take too many units offline at any one time, as doing so can result in an operating deficit, which can be compounded by your in-place debt service obligations.
REFM offers Excel-based template products that can help you carefully model out executing on a value add strategy. You can find them here:
Feel free to post questions below.