Manufacturing the Value-Add Opportunity

In these market times, if you are a real estate investor, then you are familiar with the term “Value Add,” but if you are not familiar, value adds simply means doing something to a property to improve its value.  Typically, this refers to cash flow properties, more specifically apartments, but the term and its application can be applied to any commercial income-producing property, and it means you are doing work to increase the cash flow, which increases the value.  It may include doing physical upgrades to get higher rents, bringing in new management to run the property more efficiently, or filling vacant units with paying tenants.  All of these things would increase the cash flow, which increases the value, thus making it a “Value Add” opportunity or project.

Typically, when a “value add” opportunity is taken out to market, it is advertised as such, and usually, these properties are distressed, have a lot of deferred maintenance, occupancy issues, and/or have some other functional problems such as poor management or negligent ownership. In most cases, these deals are priced very inexpensively and are perceived to be a great deal.  They are easy opportunities to identify, and if the property is in a decent location, the competition can be very fierce, and many investors are lucky to have a short window of time to perform due diligence and execute a contract.  

In most instances, these “value add” opportunities are typically in neighborhoods that would be classified as a “C” grade or even a “B” grade neighborhood on a scale where “A” grade neighborhoods would be considered the most desirable and “D” would be considered economically challenged and crime-ridden.  It is not very common to find a true “value add” opportunity in B neighborhoods, and it is extremely rare to find a true “value add” in an “A” class community.  

Typically, most of the “value add” opportunities have too many problems that conventional bank financing is not an option.  Investors trying to get into these deals are forced to either pay all cash or secure some type of bridge financing to get the deal. After that, they have to hit a carefully projected proforma to get the cash flows coming in and seasoned so that they can either sell it or obtain a conventional loan.  It is because of the upfront cash needed to purchase and then bring the property to where it needs to be that most of these deals are in the “C” grade neighborhoods that are sought after.  

In this market of new opportunities of the “value add,” there are deals to be had across any property class; however, often, the more expensive ones in the “A” class are either overlooked or not recognized because, on the surface, it may appear to be a performing property but once you dive in and peel back the onion you may discover a great opportunity, or you may be able to “manufacture a value add” opportunity where many others have failed to recognize it even existed. 

In the Cincinnati market, for example, most C-class apartment deals will trade in the $20,000 - 25,000 dollar range, B-class deals will trade in the $25,000 - $35,000 range and A-class deals will range anywhere from $35,000 - $60,000 per door and sometimes even more if it is a new construction product.  When it comes to purchasing a “value add” project, you can expect to pay 8 – 10,000 less per door than these figures (give or take) and then inject approximately 3- 5000 of capital per door, thus having the remainder for your profit.  Seems pretty simple, right?  Well in theory, it is, but I can tell you there are great opportunities missed because investors are so focused on finding a property that is distressed and has all the signs of a classic “value add” opportunity that they will oftentimes overlook that A class property, that is fully occupied, but under rented, the deferred maintenance may not be that great, the management has the perception of doing a good job (note:  I said perception because at one time they probably were doing a decent job but they have become outdated for the market and property and are no longer maximizing the properties true potential) and the price is much higher than the opportunities they are comparing to,  which would be the distressed C and low B class deals.  

Now I know what you’re thinking: “Sure, sounds good in theory, but when has this happened?”  Well, I’m not only going to describe in theory, but I’m also going to outline a few examples of an advertised “value add” opportunity as well as some that were manufactured. After you read these case study examples, you will then ask yourself which opportunity you would prefer for yourself, and then maybe you will view these types of opportunities as possible investments for your portfolio.

Example 1 - This property was a 24-unit property in a class-A area in Northern Kentucky, maybe 3 miles from downtown Cincinnati.   The property was owned by the same family for thirty to forty years and was maintained very well.  It was dated with older kitchens, but everything was in very good shape.  Each unit has two bedrooms, hardwood floors, and there were garages for tenant use.  Other tenant features included tenant-paid heat and water.  The landlord had kept this property at 100% occupancy and rarely had a vacancy.  When we analyzed his rent roll, we discovered that the majority of his tenants had lived there for fifteen years or more.  One of the glaring things we noticed was the level of rent he was achieving.  The average rent for one of these units in this prime location was $625 per month, but some of his older tenants were paying even less than that.  Our team did some market research, and we felt that we could easily achieve $800 per month if we did some updating to the interior of the units.  The property was purchased for $1,000,000, and the seller gave a credit of $10,000 for some roof work that needed to be completed. 

We put together what we felt were sufficient upgrades to the units to help us achieve the higher rent.  The cost to make these renovations was approximately $5,000 per unit.  We were calculating an increase of $175 per month, or an annualized $2,100 increase in revenue for a $5,000 investment when you do the math, that’s a 42% ROI (return on investment) for the updates to the property.  

The construction on the new units started, and we found out that we underestimated the market on these and wound up fetching $850 per month in rent instead of the $800.   With a $120,000 investment into the units, the income increased by $64,800 per year.  The value created on this was over $600,000, making the fair market value of this property close to 1.6 million dollars.  So when you factor in all the costs of about $1.3m, you can see where this class A value-add had a hidden opportunity to create $300,000 of equity in as little as 18 months.  

Example 2 -- For our second property, I’m going to talk about an advertised class C deal in Cincinnati.  This property consisted of 99 units, and it was plagued with every issue you could imagine.  Vacancy, deferred maintenance, several units that were down, major items needing to be replaced such as roofs, plumbing lines, windows, exterior curb appeal, and even some structural issues needing to be addressed.  The property was purchased for 1.355m ($13,686 per door), and the renovation budget of $5,202 per door ($515,000) was set.  One of the problems going into this was the property realistically needed a renovation budget of closer to $750,000 to complete the needed repairs.  The end value of this property would be roughly $22,000 per door ($2.178m).   So you can see here that the owners of this property put out a lot of risk and ultimately wound up investing $2.105m to create an additional $73,000 in value.  In my opinion, this is an awful lot of work and risk in a riskier grade of property to only create $73,000 in value.  Keep in mind this was one of those advertised “value add” opportunities that were perceived to be cheap and a good deal. 

Now I’ve given you two side-by-side real, live examples of an advertised class C “value-add” and a class A “manufactured value-add” deal.  After analysis of each deal, considering all the numbers and size, which deal would you feel better about being a part of?  I’m not trying to say that all C-class value add deals are bad, but the points I’m trying to make are the following:

• Don’t overlook an opportunity because there is no initial appearance of a value add.  You need to learn the submarket fundamentals of the property and look for areas the current ownership is not capitalizing on that you may be able to take advantage of.

• Don’t overlook a property because of its initial price offering and size.  As you can see from the two examples I outlined above, the smaller, higher-class deal is a much more lucrative opportunity than the larger advertised value-added opportunity.

• Just because a property is offered up and perceived as a value-added opportunity does not mean that it truly is.  

• When you do identify a great opportunity, do not be afraid to take action. 

It’s important to remember that no matter what property type or opportunity you are looking at, it’s important to be thorough and efficient in your due diligence so that you can make an informed, calculated, but not too hasty, decision on whether to invest or not.  More importantly, it’s also crucial that you surround yourself with the proper support and team members of real estate brokers, property managers, contractors, and other supporting personnel because you can be given the grandest of opportunities but fail miserably and fast if you do not execute them properly.  Finding and identifying the opportunity is only the beginning of a successful value project.