Profiting from real estate investments is a matter of being able to read the market you’re entering, and how it affects the property you’re interested in. Many real estate investors take the traditional buy-and-hold approach with residential and commercial properties, generating revenue from rent-paying tenants. Others seek to offload a property quickly once it has appreciated by a desired amount, often referred to as a ‘value add play.’
A value add property is one that can be bought at a reasonable price, and with improvements could potentially be sold for far more.
When you buy and hold a piece of real estate, your profits come from the money paid by tenants occupying the property. But to keep tenants happy and attract new ones, necessities like regular maintenance will eat into your profits.
On top of this, if you’re lucky, a property will already have the amenities people are looking for, and/or be situated in a market that can support businesses already present. Otherwise, you’ll need to invest significantly in improving the property.
Unfortunately, the cost to pick up properties that are already squared away will be high, meaning it can take some time before you start to see returns. And throughout all this, you’ll still be concerned with upkeep, and if something major suddenly needs to be fixed, it can turn an otherwise profitable piece of real estate into a money pit. This is especially the case when the tenants of a property—due to its condition, positioning, or locale—will not be willing or able to support higher rents, and the value of the property will not reflect the cost of improvements.
This is why real estate investors who want to make money off their investments while minimizing their exposure to operating costs over time look for value add plays. The goal is to identify properties where the cost of improvements can be easily offset by the resulting higher rent rates from existing and future tenants, and which will also significantly increase the eventual sale price of the property. In the long run, repeating this process will allow you to expand your holdings with larger properties, and more properties.
How do you know if a piece of real estate is ripe for a value add play?
Ideally, you’re looking for real estate that’s underpriced compared to comparable properties in the market (“comps”). This generally means older properties that are showing their age, and likely have some deferred maintenance to attend to.
Once you’ve settled on a property, you have more homework to do before you make the purchase. For example, if you’ve decided to invest in a multi-family rental, learn what tenants are paying, and walk through the units yourself and see what needs to be improved. If you can, interview the tenants for yourself and listen to what they have to say. Find out what they like and dislike about the place, and what they think needs to be done sooner rather than later.
The property you’re interested in isn’t all you should research. See what other surrounding comparable properties are asking of their tenants. If your property’s rents are lower than these competing properties, find out what has been done to get those rents up. Everything you learn from your research is going to inform you about the improvements you can make, and which of those you should make.
Improvements to the property can raise value, but it’s important to choose the right upgrades.
Unless the property you’ve invested in is brand new, or the previous owners were on top of all the maintenance or recently completed renovations—which is highly unlikely if a property is commanding lower than market rental rates—there’s going to be work that needs doing in order to raise the property’s value. Your new piece of real estate should be one where the owner has made some improvements, and has avoided letting the property slip into general disrepair, but which still has work to be done. However, it’s easy to spend too much on upgrades, or spend on improvements that current and potential tenants do not actually want or need. You need to be selective with what you choose to do, and how it gets done.
Earlier, we mentioned touring comps with higher rent rates to see what the differences may be compared to yours. If you’ve invested in an apartment complex, your goal should first be to figure out how much it would cost, per unit, to bring your property up to par with competing apartments. But as you do this, keep in mind that it is rarely necessary to go with the most expensive renovations. Spend less where you can.
Let’s say that you’ve determined that it would cost you $9,000 per unit to install granite countertops, new cabinets and tile in the kitchens and bathrooms, and do some repainting.
But if your property is in a less desirable neighborhood, your research may show that this remodel would only let you raise the average rent by about $200 for your existing tenants. Not only is this an expensive undertaking, especially in a larger complex, it’ll take you nearly 4 years to break even.
Instead, scale back on your upgrades, and research cheaper materials, selecting the ones that best fits your units. Instead of completely replacing the cabinets for a couple thousand dollars per unit, look into cabinet refacing. Check with multiple contractors before settling on one, or several. You can knock several thousands of dollars off the cost of renovations, per unit, simply by not pulling the trigger right away on the most expensive options, or with the first contractor you find.
You can further reduce operating costs by picking improvements that are relevant both to your tenants and the local market. Spending money on a brand-new outdoor playground for your complex might sound like a good idea, it might even be cheaper than renovating every unit. But if your apartments are mostly occupied by single renters without families who spend most of their days away from their complex at work, or they are mostly older retirees, then a playground means nothing to them. Trying to charge them more rent per month for something that they aren’t getting any use out of is a quick way to get renters to start looking at options elsewhere.
On the other hand, renovated kitchens and bathrooms are things a tenant is more likely to see the value in. Adding a combination washer/dryer or upgrading the AC system are value-adds they will likely be willing to pay for. Covered parking spaces and repaved parking lots can make a property more enticing, especially in areas with lackluster parking options.
And all of these upgrades can contribute to a significantly increased sale price down the road.
The value add strategy is ideal for commercial real estate investors who do not wish to hold onto retail properties for an extended period.
Many investors who use the value add strategy focus on residential properties, but many of the same principles apply to commercial properties. Retail strip malls, in particular, are transforming across the country as property owners renovate and reposition these spaces in order to attract businesses and upscale clientele.
As with a residential value add play, you want to look for ways to keep existing tenants satisfied, and raise the overall value of the property while minimizing increases in operating costs. If you’ve picked up a retail property that isn’t fully occupied, you will need to make improvements that can attract new tenants, while simultaneously bearing in mind what businesses the local market will or will not support.
Why should you avoid properties with deferred maintenance for a value add play?
Typically, most properties suitable for a value add play do require some work, and this should always be factored into any investment. Where this becomes a problem is when the work required is extensive. Examples of this include new electrical wiring, re-roofing, or extensive plumbing work.
Properties with decades’ worth of deferred maintenance are often sold cheap, which can make them tempting to snatch up. It’s always recommended to thoroughly inspect a property for any signs of serious problems before you commit to it. It can be very expensive to address deferred maintenance, especially for electrical or mechanical systems. In the worst cases, even if you do fix longstanding issues, the property’s value will not increase enough to offset these maintenance costs.
You also must factor in the tenants. If the maintenance issues are severe enough, the property is likely suffering from reduced occupancy, particularly if there are competitively priced locations in the same market. Additionally, any tenants you do have are likely paying rents that are considerably lower than market rates, and have tolerated the deferred maintenance because they can’t afford to pay higher rents. Even if you do address all the maintenance issues, the increased property values and rent increases may not be enough to offset the costs in the short term, especially as your occupancy may initially decline as existing tenants are compelled by rent increases to move on.
The value add strategy is an excellent way to profit from multi-family residential and commercial properties. The potential time to profitability after purchase can be significantly faster than traditional buy-and-hold strategies, and it can allow you to build cash reserves for future ventures. If you’re looking for the capital to get started with your own value add play, contact Socotra Capital to learn more about the loan services we provide.