What does it mean to invest in a value add deal? Should I invest in a value add multifamily real estate deal?
A value add multifamily real estate deal is a deal in which a property is purchased and then through either physical improvements or management improvements (or both), the performance of the property and resulting net cash flow is substantially improved over a relatively short period of time.
Whether you should invest in a value add real estate deal really depends on the level of comfort that you have with doing these types of deals yourself or the experience level of the investment firm you are working with. If you don't have experience implementing this type of business plan in the multifamily real estate world, I strongly recommend that you invest passively at first with an experienced investment firm until you become familiar with the process and feel confident that you can do it yourself.
It is very possible to turbocharge your returns by investing in these types of real estate deals for two reasons.
- These types of deals are designed to significantly change the cash flow and performance of the underlying multifamily property.
- Like most real estate projects, the capital stack includes some level of debt which usually serves to amplify the returns to the equity owners.
Value Add Cash Flow Improvements
In a typical “core” real estate investment, the investors rely on gradual rent increases to improve the performance of the property over time. With value add multifamily real estate investments that gradual increase to income is usually greatly accelerated because the property is usually undergoing significant renovation to both the exterior and interior spaces. As a result of these improvements, potential renters are willing to pay significantly more rent to live at the property than they would have prior to the renovation of the property.
A perfect example of this is the renovation of a kitchen in a unit. Let's say the cost of that kitchen renovation is approximately $5,000. After doing a market survey, you determine that a newly renovated kitchen should allow you to increase rents by $150 per month when you rent the apartment to the next prospect. If we assume a 6% cap rate, that kitchen renovation that cost only $5,000 to complete should increase the value of the property by approximately $30,000. That is how a value add strategy significantly increases the value of the property and, as a result, the returns to investors.
Let's compare that to a typical “core” investment where that annual rent increase would have been approximately 3%. Let's say the rent was $1,000 and we were able to increase the rent by $30 per month when we re-leased that apartment to a new person. Again, assuming a 6% cap rate that means that the $30 rent increase would have increased the value of the property by a total of $6,000.
As you can see, the value add strategy example added considerably more value to the property much quicker than a traditional core investment strategy would have.
How Does Debt Impact Value Add Real Estate Investments?
The use of debt or leverage can also be used to significantly increase investor returns in value add real estate investments.
It is very common for the acquisition cost of an apartment community to be paid for in part by borrowing money from a bank. When adding that debt or leverage to the capital stack when acquiring a property, the investor level returns will likely be significantly higher than if the investor paid cash for the entire property.
What is extremely important is that the amount, timing and terms of the debt be managed very carefully so as to not put the project in jeopardy during times of reduced occupancy. Making your loan payments is never optional and therefore the property must generate enough cash flow to make the debt service payments. If it doesn’t, the bank may foreclose on the property.
As indicated above, if you don't have experience implementing value add strategies using debt in the capital stack, I strongly encourage you to passively invest with an experienced investment firm until you are able to do the necessary homework and feel comfortable doing this on your own.
As you can see, implementing a value add real estate investment strategy can be extremely profitable to the owners of that property. The use of leverage can even further amplify that profitability or the investor returns. As is always the case, the type of value add strategy implemented and the terms of the debt are critical components that require expert management in order for the investors to earn turbocharged returns.