What is every entrepreneur's challenge? Adding value. (Part 2/3)
Continuing the discussion about the three primary models of real estate entrepreneurship with value-add development.
Topics:
What is the value-add model?
Advantages & disadvantages of value-add development
For those looking to get their feet wet in real estate investing, the value-add model offers an appealing middle ground between the heavy lifting required by the merchant builder model (which I discussed in the first part of this series) and the high level of resources demanded by the build-to-suit model (which I’ll discuss in the next edition).
What is the value-add model?
The value-add model focuses on purchasing an underperforming property, improving it substantially, and then selling it for a profit. Unlike the merchant builder model, which creates a new asset based on perceived opportunity, the value-add model targets an existing asset for intensive renovation and operational improvement, ultimately aiming to increase an asset’s income potential and market value.
Value-add improvements often include major upgrades like installing new floors or appliances, adding desirable amenities, changing unit layouts, and addressing deferred maintenance issues. It’s also common to optimize operations via stronger management and reposition the asset in order increase occupancy rates, raise rents, and maximize returns at sale.
Why choose value-add development over another pathway? There are a few reasons:
Less capital-intensive: For entrepreneurs with limited capital, the value-add approach allows you to invest in lower-cost properties primed for improvement.
Profit potential: When executed successfully, the value-add model can yield substantial profits in the near term.
Lower risk: Value-add development typically carries lower risk than ground-up. The structures and neighborhoods already exist, which reduces uncertainty.
That’s not to say that value-add development is without risk. Implementing a value-add strategy demands careful planning, effective project management, and a thorough understanding of local markets. Inexperience or mismanagement can lead to costly setbacks and negatively impact your total returns.
Value-add development in action
Imagine a 100-unit 1970s apartment complex with a purchase price of $10 million. Upgrading the 100 units with new kitchens, bathrooms, flooring and paint might cost around $5 million, resulting in a total project cost of $15 million. Better screening and new leasing incentives could increase occupancy from 80% to 95%, while gradually raising rents could provide another $300,000 in net operating income (NOI). After 5 years, the property might sell for $18 million, yielding an internal rate of return (IRR) of around 15%.
Alternatively, consider a Class A-/B+ office building with 175,000 square feet and an acquisition cost of $35 million. You could make updates like modernizing the common areas and upgrading HVAC systems for $5 million. At the same time, you’ll have to work on filling vacancies and raising tenant rents to market. After the renovation and a total project cost of $40 million. With a loan-to-cost of 80%, equity of $8 million and debt of $32 million, the property might sell for $50 million three years later. This would leave you with around $18 million in proceeds to distribute to investors.
Lastly, there is one other approach to consider: Loss to lease. Loss to lease is the difference between the market rental rate of a unit and the most recent rent charged for that unit. When you look for value-add properties, the easiest way to create value is not by doing a massive renovation, but simply by taking under market rents and raising them up to market. This creates value with little work, expense, or risk. Typically, this lower-risk value-add approach can be implemented by adding low-hanging fruit like fresh paint and new appliances, new hardware on the cabinets, and new fixtures in the bathrooms.
These are just some examples of how value-add strategies can work. There are a multitude of ways to approach a project and it is important to recognize the impacts of interest rate fluctuations on this approach as it can vastly impact exit cap rates and sales prices.
Tips for success
If you're considering the merchant builder model, here are some tips to increase your chances of success:
Choose your property carefully: Look for assets that have untapped potential but are not in such disrepair that renovation costs become prohibitive. Conduct thorough property inspections to uncover any hidden issues that might affect the feasibility of your project.
Take care with finances: Develop a detailed budget and financial plan for your project. Account for all expenses, including acquisition costs, renovations, and ongoing operational expenses. Secure reliable sources of financing (such as loans, investors, or partnerships) well in advance.
Work with people you trust: Assemble a team of trustworthy professionals and collaborate with experienced mentors or advisors who can provide guidance and support while you learn the tools of the trade.
Create a great property experience: Implement efficient property management practices to reduce vacancies, increase tenant satisfaction, and maintain the property's overall appeal.
Risk Mitigation: Be prepared for unexpected setbacks. Have contingency plans and reserves in place to handle unexpected costs or market downturns.
Still have questions? Feel free to reach out to me on LinkedIn! I’m always happy to strike up a conversation.
This week’s notes from half-court…
ESPN is showing a lot of movement in the top 90 player rankings! Shai Gilgeous-Alexander's rapid ascent into the NBA's elite underscores his relentless work ethic and untapped potential. Meanwhile, Lauri Markkanen's stunning breakout season was a testament to the Jazz's player development program—great to see!. Both bode well for their teams' futures. You can read more here.