As a real estate investor, one of your goals may be to earn current cash flow from your properties, as well as compound your capital from appreciation in the underlying asset. 

One of the best ways professional investors pursue this is through a value-add real estate strategy.

In this article:

1. What is value-add real estate?
2. How does value-add compare to other real estate strategies?
3. Examples of value-add real estate investments
4. What to look for in a value-add investment
5. Understanding 'Yield to Cost' in value-add investing
6. How to find value-add investment opportunities

What is value-add real estate?

Value add real estate is a commercial real estate investing strategy where a operator purchases an existing asset with in-place cash flow that is not operating at its full potential. The investor aims to increase cash flow and value through various physical and operational improvements. 

As most commercial properties are valued based on their income-generating potential, by increasing the property’s net operating income (NOI), the owner increases the property’s valuation.

Like most commercial real estate investments, value add real estate investors will often use a medium to a high amount of leverage to acquire property to take advantage of the naturally strong cash flow profile of commercial real estate. 

Once the owner has increased NOI, they can generally either:

1. Refinance the asset
2. Pull out equity from the higher-valued project
3. Keep it for a long-term hold
4. Exit the deal entirely via a disposition (most common)

In all cases, the owners and investors capture the equity created through the improvements in value. 

How do value-add properties compare to other real estate investment strategies

Value-add investing sits higher on the risk curve than other strategies, although it is not as risky as new development or opportunistic developments as there is an existing asset and cash flow in place. 

Here is a high-level overview of the four real estate strategies: 

1. Core Properties are typically the lowest risk of the strategies listed here and are primarily targeted for existing income. 
2. Core-Plus Properties bear slightly more risk than Core investments and may require light property improvements, tenant repositioning, and stabilizing the existing asset’s cash flow.
3. Value Add Real Estate requires more substantial property improvements, including the redevelopment and repositioning of an asset. These improvements can range from light value-add improvements to heavy value-add investments. 
4. Opportunistic Real Estate generally refers to ground-up construction and development projects and/or property conversion from one use to another (e.g., office to multifamily). 

Here is a look at how these real estate investment strategies compare:

In recent years, the implementation of value-add strategies in the private real estate sector has been on the rise primarily due to the compelling benefits these strategies offer, including potential for higher returns and improved asset value.

As property prices continue to rise as more capital comes into the market to compete for returns, traditional buy-and-hold strategies may not deliver the desired returns, leading investors to seek alternative methods to enhance profitability.

Examples of value-add real estate investments

There is no shortage of ways for operators to add value to a real estate asset.

The methods will be mostly governed by its relative positioning in the local market and how it competes for renters with other comparable housing units in the area. There are also variables on the asset, including

• What is driving the property’s NOI
• Where there is room for improvement
• Whether the operator wants to take on a light, medium, or heavy value-add business plan. 

Here are several examples of operational enhancements for value add projects:

• Interior Upgrades
• Exterior Upgrades
• Creating more leasable space
• Replacing the property management company
• Improving the rent roll quality of the building
• Repositioning or rebranding the property

Interior upgrades

It's not uncommon for upgraded units to immediately attract higher rents, which can be done gradually to avoid high vacancy levels.

Interior upgrades can range from modest (new paint, carpet) to more substantial (unit reconfiguration). Updating old wiring and plumbing is also critical during any value-add renovation. 

Exterior upgrades

Painting, landscaping, replacing the roof and windows, and adding selective outdoor amenities (e.g., a fire pit area, outdoor kitchen, replacing a pool deck, or adding a dog run) can add value to any property. 

While exterior upgrades improve quality of life, this can be a less clear reason for landlords to attract higher rents as everyone in the community benefits equally and cannot be tied to individual apartments.

Creating more leasable space

Owners should be creative as they look for ways to create more leasable space. This could include, for example, finishing a basement that can be repurposed for resident use. 

An owner might also look at converting a garage into living space. In larger apartment communities, adding Amazon delivery lockers and/or adding storage cages has become more popular as tenants are willing to pay a premium for these amenities. 

The rise of Accessory Dwelling Units (ADUs) in Los Angeles provides a great example of creating additional leasable space.

Many multifamily operators have been acquiring smaller apartment complexes and adding ADUs to significantly enhance the value of the investment. For example, a simple ADU strategy could be:

• Find an apartment complex with ample yard or parking space that isn't fully utilized
• Add two ADUs to the property, effectively increasing the number of rentable units from 10 to 12
• ADUs create an additional stream of rental income and increase the property's overall Net Operating Income (NOI).

This approach is particularly relevant in markets like Los Angeles, where housing demand is high and recent changes to state law have made it easier to construct ADUs. By adding these units, the investor is not just creating more leasable space, but also significantly increasing the value of their initial investment.

Replacing the property management company

Many owners have long-time property managers in place who may not be performing their duties as effectively as they could in supporting a well-maintained and sought-after rental community. 

This may be evident in situations with low lease collections, high vacancy, and slow response times for repair and maintenance (R&M) requests. Re-bidding the contract can result in better service—oftentimes a lower price, reducing operating expenses. 

As an example, imagine you invest in a 20-unit apartment complex generating $500,000 in gross potential revenue, managed by a firm charging $30,000 annually, with slow lease collections and a 10% vacancy rate.

Deciding to re-bid the contract, you switch to a more efficient firm that charges $28,000 annually. With their improved management, the vacancy rate drops to 5%, increasing the annual rental income by $25,000.

Besides saving $2,000 in management fees, the change brings in $25,000 increased income and better tenant satisfaction, highlighting the benefits of periodically re-bidding property management contracts.

Improving the rent roll quality of the building

A rent roll is a management tool used by commercial real estate operators that details the lease information and helps landlords track the start and end dates of contracts and rental income.

With the new management team in place, tenants from underperforming units can be evicted, and the management company begins to enforce stricter policies to ensure on-time payments. 

As the quality of the rent roll improves - NOI can be increased or even become higher quality through the value add improvements of improving the rental and leasing management.

Repositioning the property

‍While an owner works to execute physical and operational improvements, they should simultaneously embark on a repositioning the property for a different use, or rebranding of the property away from its former tenant mix.

Building 77 in Brooklyn Navy Yard is a prime example of a repositioning value-add strategy. This former World War II storage facility was redeveloped into a vibrant, multi-tenant industrial hub, increasing its Net Operating Income significantly.

This transformation, which included major renovations and a rebranding, turned a once outdated warehouse into a bustling business center, attracting tenants from various sectors. The process, however, took several years, highlighting the importance of considering timelines in value-add investments.

What to look for in a value-add investment

Investors seeking out a value-add real estate deal will want to look for the following: below market rents (usually 20-30% loss to lease), low occupancy rates, low economic occupancy rates (i.e., the number of people paying rent), physically outdated property (exterior and interior), and under or mismanagement. 

There are three categories of value-add properties based on how much work or capital investment needs to go into the property to generate higher values.

Light value-add

This generally entails addressing any deferred maintenance and inexpensive improvements, such as refreshing the units with new paint, carpet, lighting, plumbing fixtures, and USB electrical outlets. 

Some exterior improvements may include upgraded landscaping, new paint, re-striping the parking lot, or renovating the amenities. Renovating amenities is a great strategy, as it can be done without losing revenue or disrupting tenants.

Light value-add improvements will make the property look better but require limited capital investment.

Medium value-add

Medium value-add improvements include a range of the light value-add improvements noted above but may also include more expensive upgrades like fully renovating bathrooms and kitchens and making a few capital improvements like replacing HVAC systems or a roof. 

Many successful investors find that medium value-add properties provide the best bang for their buck for their commercial real estate purchases.

Heavy value-add

A heavy value-add strategy contains everything from a light and medium value-add strategy but may also include gutting the property to the studs. 

The owner may reconfigure walls, add or remove a building, and invest in expensive new amenities such as an in-ground pool or community center.

When assessing value-add investments in real estate syndications (which is the most common way investors can access value-add strategies), most investment materials will outline how the operator plans to add value to the investment - which is typically a mix of operational enhancements.

Understanding 'Yield to Cost' in value-add investing

In evaluating value-add real estate investments, a key metric that investors should pay attention to is the 'Yield to Cost'.

This is calculated by taking the current cash flow yield (i.e. the in place cash-on-cash return) plus the upside yield from the value add strategy (i.e. the improvements), and dividing it by the sum of the acquisition price and the capital investment. This equation essentially represents an investment's potential return, factoring in the current state of the property and the capital expenditure improvements needed to enhance its future earning potential.

The beauty of the Yield to Cost metric is that it captures a lot of the moving pieces in a value-add real estate investment. It provides a more comprehensive picture of the potential return on investment than relying solely on capitalization rate, which doesn't account for improvements that can boost a property's income-generating potential.

By factoring in the upside yield – which represents the potential increase in income after improvements – Yield to Cost provides a more accurate estimation of the return on the capital spent on both acquisition and improvements.

As an example, lets assume a investor identifies a property for sale for $1,000,000, that is currently generating a Net Operating Income (NOI) of $50,000 per year.

Current Cash Flow Yield = NOI / Acquisition Price

= $50,000 / $1,000,000 = 5.0%

The investor plans to make capital improvements of $200,000, which they predict will increase the NOI to $100,000 per year. The Yield to Cost is calculated by adding the Current Cash Flow Yield and the Upside Yield and dividing by the sum of the Acquisition Price and Capital Investment:

Upside Yield = Increased NOI / (Acquisition Price + Capital Investment)

= $100,000 / ($1,000,000 + $200,000) = 8.3%

The reason this numbers is different is due to the higher return on the capital improvements - generating $50,000 of NOI from just $200,000 of investment.

Value-add return

= $50,000 / $200,000 = 25%

This example demonstrates how Yield to Cost takes both the current and future potential yields into account, providing a more holistic view of the potential return on investment. This is why often Value-Add investments can trade at lower capitalization rates, as buyers know that the yield of the asset can be improved through a value-add strategy.

Lastly, one aspect that the Yield to Cost fails to consider is the timeline. Specifically, it does not account for the time required to achieve the projected yield.

This can be a significant oversight as the time to get to the Yield to Cost might be longer than anticipated, which could affect the overall return on investment. Delays in renovations, permit approval, or tenant turnovers can prolong the timeline, thus affecting the investment’s ultimate profitability.

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How to find value-add real estate properties

Value-add real estate can be found in virtually every community.

Here are some ways to identify value-add assets in your target geographies:

• Real estate agents
• Real estate investment groups
• Online listings
• Crowdfunding platforms

‍Real estate agents

Real estate agents have their ear to the ground and are an invaluable resource when looking for off-market real estate deals. 

When assessing whether a property has good value-add potential, an agent can also help compare properties to other local comps. These comps will help identify what improvements (physical or otherwise) are needed to bring the property up to market rate. 

Real estate investment groups

There are many formal and informal real estate investment groups. These groups are a great way to network with other successful real estate investors and learn about available value add investments.

Many real estate investors will share their best execution tips and techniques with their peers through groups like these.

Online listings

Many online platforms, like CoStar and LoopNet, can be used to find value add real estate for sale. Other platforms, like Reonomy, allow users to search for properties based on certain characteristics like age and most recent sale. 

For example, someone might search for properties at least 30 years old that have not been sold in the past 10-15 years. This could signal that the property is ready for value-add improvements and may be worth an off-line conversation with the owner to gauge their interest in selling.

‍Real estate syndications

Real estate crowdfunding platforms are a great way to search for value-add real estate deals from syndicators around the country. Sponsors use these sites to connect with debt and equity investors who want to own a fractional share of real estate deals. 

One of the primary benefits of investing in value-add real estate using a crowdfunding platform is that the featured deals are managed by an experienced sponsor.

Investing alongside a sponsor (vs. directly purchasing an investment property) allows the investor to earn passive income without the day-to-day responsibility of the business plan execution. 

HoneyBricks, for example, works with leading sponsors and features hand-selected and professionally managed US real estate for as little as $1,000.

The bottom line 

Value-add real estate can be an excellent investment strategy for achieving higher returns with additional risk. This is especially true as land, material, and labor costs continue to climb. 

Oftentimes, the acquisition and improvement costs still cost much less than it would cost to build a property from the ground up. It’s not an easy strategy (especially compared to buying an already stabilized asset). The strategy is understandably predominantly executed by experienced real estate operators with successful track records of value-add projects.

If you’re interested in investing in real estate but unsure you want to own physical property, consider starting with fractionalized commercial real estate investments with HoneyBricks.