Oct 4, 2022
"Value-Add" investing means buying a property and upgrading it with the goal of boosting its value.
“You get what you pay for.” You’ve heard that expression before. If you’re shopping for a car and buy a piece of junk to save a few bucks, you’ll probably end up paying through the nose for repairs and maintenance. On the other hand, if you’re a gearhead and buy an old car and restore it, you may end up with a classic worth more than the money you put into it. In the latter case, your understanding of the classic car market and mechanical skills, plus some sweat and cash, added to the car’s value.
Value-add real estate investing means injecting expertise into the process of buying and upgrading a property with the intention of increasing its value by more than the cost of the upgrades.
How does it work? Let's assume we have 150 apartment units built in 2002 for which we charge an average of $1,200 per month. Our units have not been updated since they were built 20 years ago. Several comparable properties in the area are charging between $1,300 and $1,500 per month for similar units. These nearby properties were renovated in the last five years and come with granite countertops, stainless steel appliances, modern bathroom fixtures, vinyl plank flooring, new light fixtures, and fresh paint.
After studying the market and gathering quotes from contractors, we believe we can charge $1,400 per month for rent if we upgrade our units with features like those found in comparable properties at a cost of $20,000 per unit.
After our renovation program is complete, our revenue will increase by $360,000 per year ($200 additional rent x 150 units x 12 months) at a renovation cost of $3,000,000 ($20,000 x 150 units). That means we will earn an annual rate of return of 12% on our investment ($360,000 ÷ $3,000,000). Is that good?
Was our renovation program worth it? To answer that question, we need to compare 12% to the annual rate of return we should expect to earn on the type of property we own. This is known as the market capitalization rate (more commonly the "cap rate").
The cap rate is the expected annual rate of return on a real estate investment property. It is equal to the property's net operating income divided by its market value or purchase price.
Net operating income (NOI) is a property’s annual revenue reduced by its annual operating expenses (essentially all expenses except for loan payments and income taxes).
Cap Rate = NOI ÷ Property Value (or Purchase Price).
Cap rates vary depending on the type of real estate, a property's geographical market, the quality of the property, the predictability of its cash flows, and other factors too numerous to list here. But simply put, the cap rate is the annual rate of return an investor expects to earn from the property based on the property's risk. The higher the risk, the higher the cap rate because an investor would expect a higher annual rate of return to compensate for the higher risk.
Across the United States today, multifamily cap rates are historically low. According to CoStar, the average multifamily cap rate in the U.S. today is 4.92%. Its average over the last 10 years has been 5.75%, and it typically ranges between 5.24% and 6.26%.
To keep the math simple, we will use 5% as the market cap rate for our property and assume it does not materially change in the near-term (the three years or so it would take to execute our value-add plan).
So, if our renovation program earns a 12% annual return and a "normal" annual return for our type of property is 5% , then yes, our renovation program was worth it!
How much value did we create? In our example, we will use our property's increase in rent as a proxy for its increase in NOI because we do not expect day-to-day operating expenses to change after we complete the renovation program.
To measure the value we created, let's rearrange the cap rate formula above:
NOI ÷ Cap Rate = Property Value
and that means...
Δ NOI ÷ Cap Rate = Δ Property Value
where Δ means "change in."
So, let's plug in the values from our example:
$360,000 ÷ 5% = $7,200,000
Our renovation program increased the value of our property by $7,200,000 at a cost of $3,000,000 for a net value creation of $4,200,000! Even if the multifamily real estate market declined and our property's market cap rate rose to 6%, our net value creation would be $3,000,000.
To illustrate the point another way, let's see what happens if the market cap rate for our property is 12%. I bet you already know what to expect - that we would break even on the renovation program. And you're right.
$360,000 ÷ 12% = $3,000,000
If the market cap rate for our type of property was 12%, then by spending $3,000,000 on renovations we would have increased the value of the property by $3,000,000 for a net value creation of $0.
Is value-add investing really that simple? Well, the math may be simple, but buying a property at the right price and executing this type of business plan is anything but. There is no low hanging fruit. It takes careful study of a market, disciplined analysis, adequate capital, astute property management, a balanced and organized team, and focused asset management to make it all happen.
And it doesn't happen overnight - executing a value-add program like this takes two to four years before the full value is realized.
This is what Volhawk does so our investors can enjoy the cash flow, tax benefits, and portfolio diversification of investing in commercial real estate without having to do the work.
If you'd like to learn more about how Volhawk can help you create passive streams of income from commercial real estate, connect with us here and one of our team members will be in touch to schedule a call.
The example presented above is fictional and the results presented are used only to demonstrate the ideas conveyed in this article and are not guaranteed.