In the multifamily real estate space, there’s no shortage of strategies you can use to grow wealth. One promising real estate investment strategy involves finding (and purchasing) properties you’ll gradually improve to achieve higher revenue potential. We call these opportunities “value-add properties.”
These properties may require hands-on effort and a more active involvement approach, but they can deliver higher returns when managed well.
In this article, we’ll talk you through the process of finding (and investing in) value-add properties.
What Are Value-Add Properties?
Once again, value-add properties are real estate investments that need improvements or renovations to reach their optimal value and income potential.
Investing in a value-add property could involve physical upgrades like modernization, installing energy-efficient systems, or adding amenities. It may also include operational changes, like increasing occupancy rates or enhancing management practices.
Unlike stabilized properties, which perform at their full potential, these real estate investments present opportunities for growth but demand more effort and capital.
The Pros of Investing in Value-Add Properties
Pro #1: Higher Returns
Value-add properties can deliver significant returns because they allow you to actively increase the property’s net operating income.
For example, upgrading a neglected apartment complex with modern finishes and better security is a decision that can be used to justify higher rents. Suppose a property had units renting for $800 per month; after $10,000 in upgrades per unit, rents could reasonably increase to $1,100. Across 20 units, that’s an additional $72,000 in annual income, directly raising the property’s market value.
Pro #2: Tax Benefits
Renovation costs may be tax-deductible. Investors can also benefit from depreciation deductions, which offset taxable income. For instance, renovating a 10-unit property may cost $100,000 but save thousands annually in taxes, softening the financial burden of improvements. Other programs like cost segregation accelerate depreciation on certain components, reducing taxable income.
Pro #3: Market Opportunities
Analyze underperforming properties in strong markets and turn them into money-makers. The ability to adapt a property to meet current market demands often translates to outsized returns (compared to properties operating at peak performance).
Pro #4: Control Over the Investment
Value-add properties give investors direct control.
You can add community amenities such as a gym or shared workspace to a multifamily property to attract higher-quality tenants.
You can even make operational changes like digital rent payment systems, to reduce overhead to improve cash flow.
You call the shots.
The Cons of Investing in Value-Add Properties
Con #1: More Risk
Higher returns come with greater risk.
In the case of value-add properties, renovation projects intended to introduce new value can uncover unexpected problems and set you back financially. As with anything, what you see on the surface isn’t always representative of what’s behind the walls.
Once you’re deep into the renovation process, you realize that you need to make extensive plumbing or electrical repairs, which could delay move-in and set you back thousands of dollars. These unforeseen costs can erode profits and even jeopardize the investment if not managed carefully.
Con #2: Requires a Lot of Time and Effort
An investment property like this requires active management. Overseeing renovations, managing contractors, and improving operations is time-consuming, and managing a project isn’t a skill that everyone has.
So, consider this a warning: without experience or a solid team, this workload can be overwhelming.
Con #3: It’s Capital Intensive
The initial investment in purchasing the property and funding renovations can be substantial. A small multifamily property might involve a purchasing price of $500,000 and $150,000 in upgrades.
Therefore, you need to account for higher interest rates or additional borrowing if you want to proactively cover those unexpected costs.
Con #4: Uncertain Market Conditions
Changes in the local market or economic downturns affect success. If the local economy falters, the property may not achieve its projected income goals.
Value Add Strategies
There is more than one way you can approach a value-add property. They offer flexibility in investment strategies, which is why I love them. Here are some common approaches.
Strategy #1: Flipping
Renovate and sell the property for a profit. As an investor, you can purchase an old or undervalued property, put some sweat equity into it, and sell it for more. Flipping works well in a real estate market with high demand and rising property values.
Strategy #2: Invest in Upgrades
Instead of flipping, you can hold the property and continue to generate rental income after adding upgrades. Upgrades like modern appliances or better landscaping can attract tenants willing to pay higher rents.
Strategy #3: Repositioning
Change the property’s intended use. An old warehouse could be transformed into loft apartments or office space, adding sizable value depending on what’s hot on the market.
Investors seeking deals often look to reposition properties.
Strategy #4: Hold for Long-Term Appreciation
Improve the property, rent it out, earn consistent cash flow and let it appreciate over time. In high-growth markets, holding your real estate investments for several years can yield substantial capital gains while generating steady rental income.
Strategy #5: Optimize Operations
Streamline property management practices. For example, introducing efficient maintenance systems or reducing vacancy rates can improve profitability without major renovations.
Stabilized Investments: Pros and Cons
Compare value-add properties to your stabilized, core real estate investments. Stabilized properties are fully leased, require minimal improvements, and generate steady income.
Pros of Stabilized Investments:
Pro #1: Steady Cash Flow
Tenants already in place provide predictable income. For instance, a leased office building generates consistent revenue with little management involvement.
Pro #2: Lower Risk
Fewer variables make stabilized investments less risky. A long-term lease agreement with a corporate tenant ensures steady returns.
Pro #3: Less Effort
Minimal involvement suits passive investors. For example, owning a fully occupied residential building may only require occasional maintenance.
Cons of Stabilized Investments:
Con #1: Lower Returns
Profit potential is capped since these properties are already optimized. An investor in Los Angeles found their stabilized property appreciated only 5% annually compared to double-digit returns from value-add investments.
Con #2: Limited Value Growth
Without significant improvements, appreciation is slower and more reliant on market trends. A retail property in a stagnant market saw little to no increase in value over five years.
How to Find and Assess Value-Add Properties
One of the challenging things about value-add properties is finding them in the first place. To no one’s surprise, it’s hard to find opportunistic real estate investments!
But there are some insider tricks of the trade. Here’s how you can go about it.
Start by identifying markets with strong rental demand and economic growth. Cities with job growth and population increases often present good opportunities. Use tools like MLS listings, commercial real estate platforms, and local connections to identify underperforming properties.
Assessing whether a property is value-add involves evaluating its current performance and potential. Look for signs such as:
- Below-Market Rents: Properties where rents are lower than similar properties in the area often signal opportunities for improvement.
- Deferred Maintenance: Buildings needing repairs, like outdated HVAC systems or leaky roofs, often come at a discount but offer room for value creation.
- Underutilized Space: Spaces like basements, parking lots, or unused land can be repurposed to generate additional income.
You’ll have to dig into the numbers and do your due diligence in reviewing financial statements, inspecting the property, and estimating renovation costs.
If, for example, a multifamily building rents units at $1,200 while comparable properties charge $1,500, there’s potential to close that gap.
Optimizing Value-Add Investments with Ancillary Income
If you’re looking for a way to improve cash flow through your property, you can add value by incorporating income through ancillary offerings by providing additional services like EV charging stations, laundry facilities, and valet trash. JLL President and real estate expert quoted recently in this ICSC article, “Ancillary income programs become a year-round focus, and they became an important part of merchandising a property,” she says.
Multifamily properties can generate extra income by listing vacant parking spaces and unrented storage lockers to non-residents. Listing unused spaces is a simple way to maximize revenue without adding significant costs. Peer-to-peer platforms like Neighbor handle the tenant search for you and match you with renters in the area. It’s worth checking out how much your space could be rented for.
Conclusion
Value-add properties offer attractive opportunities. They come with higher risks but deliver substantial rewards when managed well. For steady income with lower risk, real estate assets like stabilized investments provide a passive alternative. The best portfolios include a mixture of both.
