A value-add property refers to any property an investor buys or sells where the value increases substantially with improvements. Investors who pursue value-add opportunities aim to improve the asset’s cash flow by making renovations, rebranding, adding amenities, or improving operational efficiency.
Typically, investors interested in value-add real estate look for properties with existing cash flow. Then, they implement strategic improvements that will increase property value and boost revenue stream over time. They might opt to add perks to attract higher-quality tenants, reduce operating expenses by choosing different property managers, or make improvements that justify higher rents.
What Exactly Are Value-Add Properties?
While individual approaches to a value-add real estate model vary, all aim to improve profits by accessing untapped resources or adding upgrades to increase value. According to a model created by Bullpen, value-add real estate has moderate to high risk, low occupancy rates or considerable capital expenses, and an average annual return of 13 percent to 15 percent.
Value-add real estate often appeals to private non-institutional investors with a willingness and ability to take on risk. Because value-add projects are often financed at medium-to-high leverage levels, investors have the potential for higher returns. In the short term, however, the risk is higher, as the properties may be renting at below-market rents or have hefty maintenance costs. At the time of acquisition, they might also be only partially leased.
Different Strategies for Value-Add Investments
For the skillful investor, value-add properties present a balance of risk and reward. They can capitalize on a previous owner’s failure to maximize a property’s potential, provided they can generate cash flow during acquisition and implement an effective strategy for adding value to the property.
Investors can choose from several strategies to achieve a positive return on investment (ROI) on their value-add investments. First, they could consider an operational value strategy, which involves adding value through operational improvements. For example, increasing efficiency in an older building by replacing traditional light bulbs with LED lights, making the property more efficient and saving thousands of dollars in energy costs.
Alternatively, investors might opt for renovation or physical value improvements. In this case, they would invest in a commercial property or portfolio in need of renovations. By completing renovations and physical improvements, they add value to the property, which can increase occupancy and command higher rents. An investor might purchase an office building with few amenities, for example. By adding perks such as dining options, a gym, or common areas, they can attract higher-quality tenants and increase cash flow.
Finally, investors could take a reposition or location value-add strategy, which involves investing in a property in an optimal location and converting its function. For example, a retail center in a low-traffic location might work better as an office park. Similarly, an empty property in an up-and-coming location is an ideal option for multi-family housing.
What Are the Risks?
Like most commercial real estate, value-add investing has a high potential for returns, along with some specific risks. For example, economic and regulatory changes frequently impact the real estate market. These can potentially decrease an investment’s value and weaken operations. Additionally, national and international market, economic, and political conditions can negatively impact the financial positions of tenants, affecting their ability to pay rent.
Meanwhile, all property owners must comply with governmental regulations concerning renovations and property use, which can impact their ability to increase a property’s value. Properties with high vacancy rates can be difficult to sell, decreasing ROI.
Property owners have no control over the demand for office or retail space in any area. If the demand decreases, their property’s financial conditions and operations may suffer. Because real estate assets are not liquid, property owners may not be able to sell the property when they need to. Finally, value-add investments are not diversified, which makes investors economically vulnerable compared to investors with a more diversified portfolio.
What Are the Advantages?
Compared to investment classes like stocks and bonds, value-add investments may have tax advantages for investors. First, if investors hold an ownership share in the property, they may claim tax deductions related to the property’s deprecation schedule, set by the IRS at 27.5 years. This means that investors can deduct 1/27.5 of the value of the property from their taxes each year for property depreciation.
Further, investors can deduct running costs such as maintenance, utilities, and other day-to-day expenses of running their investment property. If an investor has used borrowed funds for renovation or new construction, they can add the interest they pay on the loan to the basis of the property. Using the same depreciation schedule as standard commercial property, they can depreciate this amount over 27.5 years. Investors can also add value-add properties to their 1031 Exchange, deferring capital gains taxes by reinvesting the gains.
With careful planning, value-add investments can make a constructive addition to an investment portfolio, providing excellent returns and tax advantages for investors with a relatively high-risk tolerance.
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