Like every other industry, real estate comes with buzzwords, and few are as popular or ambiguous as value-add.
On paper, it’s fairly simple: adding value to a property attracts tenants, warrants rent increases, and improves returns. In practice, it’s a little more complicated.
Understandably, every seller wants to designate their buildings as value-add opportunities. Nobody’s going to advertise their listing as “pretty tapped out; not much headroom for improvement.”
But, when everyone’s super, no one is.
So, today, let’s break down value-add in multifamily real estate: some perspectives on the definition of value-add, how Birgo Capital thinks about value-add, what kinds of value-add there are, and a few strategies Birgo Capital likes to implement that add value to our acquisitions.
Value-Creation =/= Value-Realization
Depending on how you look at it, adding value could simply be achieving a better rate of return on your property by the end of the hold term than at the beginning. That definition might work as a marketing tool, but it’s not a particularly useful framework for real estate investors who need to make challenging acquisitions decisions that fit their investment theses, risk profiles, and return targets.
So, what is value-add? For starters, it is not value-creation. Transforming an empty lot into an apartment complex or salvaging a decrepit mall can produce real returns for real estate investors whose appetite for risk matches the project — but it isn’t really value-add in a meaningful sense. Instead, Birgo Capital likes to think about value-add as value-realization: improving returns by removing hurdles and accessing a property’s true value.
Value-add occurs when the marginal dollar invested in a property produces more than a dollar of value.
As real estate investors and fund managers, we like this definition for two reasons:
- It’s an actionable decision framework. Investors deciding whether to execute a value-add strategy should consider their strategy’s bottom-line ramifications from a marginal perspective. Under this framework, a $100,000 investment in energy efficiency that reduces a 6% cap rate building’s utility bill by $50,000 a year is a value-add decision that becomes simple arithmetic.
- It helps clarify what “value add” really means. Riding the wave of cap rate compression, or rent growth that keeps up with the market, is a real way to make money investing in real estate. Sitting on your building for 10 years without changing the fixtures, and earning returns because the property tracks with economic performance and the local real estate market, might be a sound strategy for some investors — but it isn’t value-add. Instead, value-add is always in addition to what’s happening in the macro, so the return on the incremental dollar is a better evaluation framework.
Most value-add strategies usually begin with a property that already has in-place cash flow, and attempts to increase that cash flow by improving or repositioning the asset. Exactly how a value-add strategy impacts real estate investors’ bottom line can vary, but in general, investors will execute a value-add with one or more of the following objectives in mind:
- Improvements that warrant higher rents
- Marketing efforts to lease vacant units
- Lowering expenses to strengthen cash flows
- Eventually, selling the asset for a price that reflects its increased value
Value-add is a powerful tool, but:
A value-add real estate investing strategy isn’t for everyone
Like most other portfolios, real estate portfolios, benefit from diversification. But, most private equity real estate opportunities will funnel investors into funds that match general sets of priorities. A fund mostly comprising core and core-plus properties is simply going to perform differently than a fund comprising mostly value-add and opportunistic ventures. Investors’ decisions to buy into one or another of these funds will be motivated by their portfolios’ structures, their appetites for risk, and their target returns.
All else equal, an investment that involves more up-front capital expenditure is riskier than a less-costly alternative; that means that value-add strategies demand a measure of liquidity, and involve some degree of risk. These strategies also usually require operational expertise. For these reasons, value-add investments may not be attractive for individual real estate investors or smaller firms if they don’t have ample access to liquidity and don’t want to roll up their sleeves. On the other hand, because risk is usually correlated with return, successful value-add deals will often offer investors higher returns than their counterparts.
However, within the category of value-add strategies, some approaches offer lower risk and greater reward.
Capital-intensive value-add vs. capital-light value-add
The most easiest breakdown for value-add real estate investing strategies consists of capital-light and capital-intensive categories.
Anything that increases return on the marginal invested dollar is value-add, but value can be added to multifamily properties in numerous ways. Generally, the lowest-hanging fruit for multifamily investors is improving the property to justify rent increases and grow the income side of the P&L.
In theory, as long as income increases more than expenditure, the value-add was successful.
Some capital-intensive ways of increasing a property’s potential value include:
- Knock down walls and expand the kitchens in all your units
- Comprehensively reconstruct failing ductwork or plumbing
- Embark on a large-scale renovation plan to migrate a building between asset classes (i.e., improve a Class C property to a Class B property by renovating common areas and exteriors)
In practice, capital-intensive strategies don’t always make sense for investors, because they disregard lower-hanging fruit that could improve returns without spending as much money. In our experience, capital-light value-adds can materially improve returns on most properties in the workforce housing space — and easier execution of capital-light strategies makes them more attractive options than capital-intensive value-add strategies.
While the term “value-add” may be associated with images of brand new kitchens, ripping out carpeting, or totally reinventing an under-utilized asset, sophisticated real estate investors can also add value in more subtle ways. Private equity firms, REITs, and institutional investors possess the expertise and scale to introduce capital-light efficiencies that add value and improve returns without introducing unnecessary risk. A few strategies we particularly like:
- Investors’ true return experience depends on actual figures, but properties are bought and sold on the basis of pro forma numbers. Pro forma, sellers can add value by deflating expenses. So, one acquisition risk is that a property represented as ripe for a value-add strategy may not in fact be well-positioned for one. Improving returns can sometimes be as simple as adjusting pro forma P&L statements to correct distorted line items, thereby reducing expenses and increasing a property’s NOI. Perhaps the property is over insured, and the seller doesn’t know it or perhaps property tax is over assessed. Reevaluating line items like insurance and tax can quickly change a real estate investors’ return experience. Experienced, institutional property owners can likely navigate these complexities better than mom-and-pop sellers — a dynamic that creates opportunity for sophisticated investors to add value immediately after acquiring a property.
- Operational efficiency can add value in other ways as well. A vertically-integrated owner that insources maintenance and management can reduce costs throughout the portfolio Smaller investors or firms that are not vertically integrated simply don’t have this advantage.
- Aggregation exit plays are another organizational opportunity for sophisticated investors. Positioning an asset relative to financial markets can access deep value by virtue of scale. Fifty 10-unit properties owned by the same seller becomes a 500-unit portfolio, which will benefit from cap rate compression at sale that each individual 10-unit asset would not access if liquidated by itself. This is a particularly unique value-add strategy, as it incorporates an element of value-add through financial engineering as opposed to the improvement of the real estate itself.
Investing into properties that offer some low-hanging fruit is also a viable, and somewhat capital-light, strategy. That approach could include:
- Common area improvements like stairwells and lobbies
- Replacing old carpet with new, durable flooring
- Install low-flow showerheads and toilets to improve energy efficiency to reduce utilities costs
Defining the parameters of a “capital-light” investment is inevitably going to involve some ambiguity, but — generally speaking — we like capital-light strategies because they can help realize value a building is primed to capture.
Birgo Capital uses this approach in the vast majority of acquisitions.
Why Birgo Capital prefers a capital-light value-add strategy
If investors just spend enough money, they could comprehensively reposition an asset and justify sizable rent increases (on paper). If the play works, investors could earn impressive returns. But, there’s three potential problems with that rationale:
- The absolute size of income increases usually doesn’t matter. Remember value-add occurs when the marginal dollar invested into a property produces more than a dollar’s worth of value. A successful value-add real estate strategy is defined less by the absolute size of income increase than it is by the relative income increase — how much more the building earns as a proportion of the value-add investment.
- Spending more capital is riskier. Value-adds are a proven strategy for capturing returns through improvements that attract and retain tenants by offering them excellent experiences, but more affordable ways of doing so invite less risk and can still substantially improve a property’s returns.
- In the workforce housing space, there’s a lot of low-hanging fruit for capital-light approaches that investors can generally find ways to add value without making capital-intensive moves.
Operational efficiencies like economies of scale or vertical integration have the potential to instantaneously add value to every property an investor buys. If investors operate properties in ways that fill vacancies, reduce costs, and improve efficiency, they can add real value without calling the bank or breaking out the heavy machinery.