“Value-Add Opportunity” What does it mean, and should I consider it?

If you have spent any time at all researching potential apartment investments within the last several years, I am certain that you have been presented with a property in which the seller and/or agent have presented the deal as a great “value-add opportunity.”

In this article, I will discuss exactly what a value-add opportunity is, how to determine whether or not a value-add program will actually work, an indication of which properties are best suited for a value-add program, and a brief discussion of specific actions you can take to make this program work best for you.

Before defining the term, it is necessary to state that, in my opinion, this term is grossly over-used.

I would estimate that at least 75% of the deals I am presented with claim to offer a great value-add opportunity.

In fact, I have looked at apartment communities that are only a few years old that claim to offer this.  You will understand why this is ridiculous on its face by the end of this article.

Although there is no actual definition, a value-add deal is one in which a potential buyer could take advantage of market disparities by adding value to the property and allowing for higher monthly rents.  This typically comes through a combination of a capital improvement program, re-positioning the asset, and increased operational efficiency.  All of these will add value to the investment.

So, given the above definition, how do we find opportunities that offer real value-add potential?  More importantly, how do we find those deals that offer the best value-add potential?

First, be careful if you’re presented with a “value-add” opportunity where the previous owner has already completed significant renovations and raised rents but is stating that you could still get another, say, 10% rent bump with “minor” additional upgrades.  These are the properties that you want to be the buyer BEFORE they get renovated.  

If I were to describe the ideal value-add investment, I would define it as the “weed in the flower patch”.  In other words, it would be an older property that is located in an area that is highly desirable (i.e., the flower patch), but is the one property that has been neglected in terms of maintenance and/or management (i.e., the weed).  It is a property like this that offers the best opportunity to increase value.

However, there are additional criteria that the property must meet in order to be successful.  Primarily, the problems at the property must be both solvable and financially viable.  If the property suffers from major structural deficiencies and/or extensive deferred maintenance, the cost to remediate the issues may be too high to recoup costs through increased rents.  Generally the increased revenue must pay for the upgrades/repairs within 4 years to make the investment worthwhile. 

Also, the property may be functionally obsolete.  For example, the unit mix may consist of all studio/efficiency and small one-bedroom apartments in a neighborhood that demands larger one and two-bedroom options. Problems such as this are difficult if not impossible to solve.

So, what we are looking for is a well-located property that is below market rent and has minimal to moderate deferred maintenance and/or management deficiencies.  It is this type of asset that offers the best chance for success.  You’re not just betting that rents go up forever but actually re-positioning the property.

Now that we have identified the property, we need to develop our value-add program.

The best way to demonstrate this is through a hypothetical example.  Let’s say we have identified an eight unit property in one of the more desirable parts of town.  The current owner has had the property for several decades and has not upgraded the units more than occasional new carpeting, painting and necessary repairs.  Because he has little to no debt on the property and prefers to just collect checks without doing much to make the property competitive, the rents are severely under market.

He is retired and now wants to sell the asset.  The units are all two-bedrooms, and currently rent for $800 per month.  For simplicities sake, we will assume the property is always fully rented.  This is key – you can’t bump rents at a property that’s 85% rented.  Something else is wrong. 

Back to our example – the owner wants to sell the property for $600,000 or $75,000 per unit.  We know that the property generates $76,800 in income annually, and through due diligence, we find that the annual expenses for this asset run at $40,000 per year.  This leaves a Net Operating Income (NOI) of $36,800.  With a purchase price of $600,000, the “going-in” capitalization rate (NOI/Purchase Price) is 6.1% – an aggressive but reasonable cap rate for the local market. 

Now, let’s assume that we invest $6,000 into each unit ($48,000 in total) for upgrades including new laminate flooring, new appliances, new lighting and plumbing fixtures and new counter and vanity tops.  Let’s also assume that post-renovation we can rent these upgraded units for an additional $150, or $950 per month.

Does this “investment” make sense?  Let’s find out.

The new “cost” of the acquisition is $648,000 (Purchase price + $48,000 in improvements) and we have increased revenue (after all eight units have been renovated and rented) by $14,400 per year.  So, our new gross revenue is $91,200 and our expenses remain at $40,000, yielding a new NOI of $51,200. 

Using the capitalization rate we calculated at acquisition (which we felt was reasonable) of 6.1%, and applying this to the new NOI results in a new property “value” of $839,344.  Under this scenario, we have increased the value of the asset by $239,344 (Current value of $839,344 less original acquisition price of $600,000) and it only cost $48,000 to do this. 

However, we also need to look at the payback time for this investment.  Since it cost us $48,000 to get a $14,400 per year increase in revenue, that equates to a 3 1/3 year payback ($48,000 divided by $14,400).  This falls within our 4 year maximum so it will bump our returns without exposing us to an extended pay-back time frame.

However, let’s say the cost to renovate is $10,000 per unit, and we can only increase rents by $40 per month.  Using calculations similar to those above results in an increased value of the property of $62,950, but the cost to renovate is $80,000.  As such, this value-add scenario results in an actual “decrease” in net value of $20,000 and would require nearly 21 years to pay back.  This clearly does not make economic sense.

This is just one hypothetical example, but it should provide you with a foundation to understand how the value-add process works and how to determine whether or not such a program makes economic sense.