The term “value-add” is one of the most often mentioned regarding real estate investing. However, value-add is a specific profile of investing, and only one within a spectrum of investment strategies.

This article outlines the general categories of investment strategy and elaborates on the details of how value-add tends to be executed and why it remains a popular strategy for many investors. Though there is no universally accepted definition or delineating characteristic between these strategies, it’s most helpful to think of an investment employing either a core, opportunistic or value-add strategy. These could be broken down into further segments, but the general characteristics for each will remain the same.

Investment strategies tend to have a strong correlation between the level of risk accepted and expected level of return. Real estate investing is no exception.

At the lowest end of the risk/return spectrum is “core” investing. Core investing tends to be fully stabilized assets. If it is a commercial property it will have tenants of institutional quality credit. Core is most often newer, Class-A buildings, located in tier-one or gateway cities. Investors pay a premium price to own such assets, but in return, they receive a steady, predictable stream of income, albeit at a lower rate of return. Core investing could be likened to owning AAA credit corporate debt. Extreme examples of these assets are the trophy office or high-rise residential towers in New York City, Chicago or San Francisco. Institutional investors such as insurance companies and pension funds typify the buyer profile for these buildings. They are often responsible for placing huge amounts of capital and are willing to accept relatively low rates of return on their investment. Here, wealth preservation is more important than wealth creation. It’s low risk and low reward. The levered returns on core investments frequently fall in the 3-5 percent range, fluctuating slightly above long-term U.S. Treasury bonds.

At the other end of the risk/return spectrum is “opportunistic” investments. These investments incur the most possible risk in real estate and command the highest potential returns.

The risk/return profile of an opportunistic real estate investment could most aptly be compared to that of a small, or mid-cap growth stock. Here, investors are not buying the current income stream, but what they believe the income stream could be in the future. The most common opportunistic play is that of a ground-up development, where a developer buys a piece of land with the intention of constructing and leasing-up a new building on the site. Alternatively, some investors/developers buy an asset and change its use, such as converting an old industrial warehouse to a mixed-use project with rental lofts and creative office space. In either case, the developer incurs substantial risk for undertaking such a project. Among other pitfalls, they may fail to secure the necessary debt and/or equity financing. They may run into trouble getting the site entitled for the proposed development. There may be cost overruns during construction. Or the market may lose appetite for the development once it’s completed, causing delays in leasing. Understandably, developers require a high rate of return on their project for assuming that level of risk. The exact timing and strategy vary significantly between projects, but the developer is likely seeking a total levered return on the project between 15-20 percent or higher.

Between these two strategies in the risk/return spectrum falls “value-add.” At a high level, value-add strategy has more risk than a core investment, but less than one with an opportunistic strategy.

Accordingly, the expected return will fall somewhere in between, likely in the 6-14 percent range. A value-add investor seeks, as the name implies, to “add value” and increase the operating income through a combination of improvements at the property. These improvements typically fall into one, or a combination of the following three categories:

Common area capital improvements

Common area capital improvementsThese present an opportunity to change the building’s “envelope” and enhance the curb appeal of the property. Frequently, properties targeted for value-add are purchased from owners who have held on as long as possible while minimizing capital expenses on the property to maximize their short-term cash flow. This presents an opportunity for a value-add investor. Common capital improvements include projects such as exterior paintwork, replacing hallway carpet, a landscape refresh, pool deck resurfacing and outfitting, or updating the fitness center with new paint, flooring, and equipment. Often these capital improvements will be made simultaneously with deferred maintenance issues ignored by the previous owner. Deferred maintenance issues include items such as replacing roofing or windows, sealing/striping the parking lot or remedying site drainage issues. Deferred maintenance expenses fix, but don’t “improve” the property. Collectively, fixing the deferred maintenance issues and investing in new capital improvements will typically allow the owner to sign new leases at an increased rental rate.

Interior unit renovations

Unit renovations are perhaps the most typical value-add play. Here, investors plan to upgrade the fixtures or materials in the individual units to attract renters willing to pay more in monthly rent. Most often, kitchen and bathroom upgrades will offer the highest return on investment. Depending on the specific market, however, interior unit renovations will include some combination of painting, resurfacing or replacing cabinet fronts, adding or replacing appliances, updating flooring, replacing fixtures, or adding backsplash. Like the common area capital improvements, buyers must carefully analyze the market and manage construction costs to ensure they receive an appropriate return on the investment in the improvement.

Management or operations improvement

Sometimes a buyer may have the chance to purchase an asset from an owner lacking significant operator experience. This may be a developer whose business model is to develop and sell projects once stabilized or simply a smaller syndication who owns maybe one or two deals. These owners may lack the experience, technology, or even need to be able to truly maximize the potential operating income for a property. A significant national owner/operator such as Timberland Partners will utilize state-of-the-art revenue management software, local or regional operating expertise, and economies of scale in purchasing power to simultaneously maximize income while minimizing operating expenses. 

Occasionally, there are other reasons why a certain purchase may yield a return in-line with a value-add strategy without having to implement the previously discussed methods of improvement.

Private markets are inherently less efficient than public markets and occasionally deals can be acquired at prices yielding value-add level returns without the necessity of implementing such a strategy. Timberland Partners remains positioned to capitalize on such opportunities, as well as prepared to execute across the spectrum of traditional value-add strategies.