Value-add real estate strategy: opportunities, risks, and rewards
When choosing among the seemingly endless options for investing in commercial real estate it’s helpful to think about how various investment choices fall along the risk-and-reward spectrum.
Rather than asking how much money they’ll make, astute commercial real estate investors begin their real estate investment analysis by asking the question, “Does this opportunity provide me with the correct balance of risk and reward that matches my investment strategy?”.
There are three common investment strategies in commercial real estate, each with its own balance between risk and reward. What’s right for one investor might be a completely wrong choice for another investor.
Three commercial real estate investment strategies: Core, Opportunistic, and Value-Add
The first step in commercial real estate investing is to understand the difference between core, opportunistic, and value-add investments. Core and opportunistic investment strategies fall on opposite ends of the risk-and-reward spectrum, while value-add provides the ideal balance.
Core Real Estate Investment Strategy
Commercial real estate investors looking for minimum risk in exchange for a predictable – but lower – return often opt for the core investment strategy. The core strategy is similar to buying a Treasury bond. Investors know they’re going to get their money back along with a yield that hopefully offsets the rate of inflation.
In multifamily commercial real estate, core properties are Class A or A+ properties in prime locations with top-of-the-line amenities, high rents and low vacancies, and professional property management. Core real estate sells for a higher price per square foot, and offers a lower capitalization rate, in exchange for the perceived lower risk of tenant default and value fluctuations.
Opportunistic investment strategy
The opportunistic real estate investment strategy is the opposite of the core strategy. Opportunistic investments carry a much higher level of risk than core properties, but the hoped-for return is much higher as well. Buying shares of an IPO of a company that has no real cash flow is an example of an opportunistic investment. Investors hope the business will generate true income by going public, and when it does, the stock price should rise.
An example of an opportunistic investment in multifamily real estate is constructing a brand-new apartment project or completely repositioning a property from one use to another. Significant amounts of capital are then invested in construction and updating to attract tenants willing to pay a higher rent rate.
Value-add real estate investing strategy is a balanced blend of benefit and risk
The value-add commercial real estate investing strategy falls in the middle of the risk-and-reward spectrum. It’s a good choice for high net worth investors seeking a realistic higher return in exchange for a manageable increase in the level of risk.
Value-add real estate property generates profit for investors in two ways. First, higher yields are generated by capturing and creating untapped revenue streams. Second, value is created by wisely investing capital into property upgrades that offer the highest level of return by balancing the upgrade cost with the incremental profit returned.
How the value-add strategy is used in multifamily investing
Year by year, across all age groups and demographics, the number of households renting where they live continues to increase. Multifamily value-add property located in neighborhoods in transition or high-demand areas let investors profit from the growing demand for rental housing while generating higher risk-adjusted returns for themselves.
There are several tactics that multifamily value-add real estate investors are using to increase property value and yields:
Increasing rents by renovating the property – exterior painting, parking lot resurfacing, interior updating with new modern décor, stainless steel appliances, and in-unit washers and dryers
Creating additional income streams – adding amenities such as storage units, reserved parking, and daycare or pet sitting services, are items that tenants are willing to pay extra for
Analyzing and refining operations – by reviewing profit-and-loss statements by line item to find expenses that can be reduced to increase the bottom line (net operating income)
Replacing existing property management– if the multifamily property isn’t being managed efficiently with an acceptable operating expense ratio or lazy managers who don’t push rents or select ideal tenants
Every commercial real estate investment strategy has benefits and risks
It’s important to note that none of these investment types are completely passive – but the amount of time the investor must spend with the property does vary with each real estate investment strategy.
Of the three strategies – core, opportunistic, and value-add – investing in value-added property offers the best balance of risk and reward. The value-add real estate investment strategy combines art with science.
Investors need to know where to look and how to find a property’s untapped potential. Once a value-add property is identified, discipline and know-how is required to implement an improvement program that maximizes yield. The value-add investment strategy generates increased cash flows during the holding period and a higher sale price when the property is sold.