Picture this: You’re driving around your neighborhood and you see an old writing desk by the side of the road. It appears to be in good condition, and you envision it in your home office. So you take it home, sand it down and refinish it to match your decor.
After some time has passed and your room is no longer a home office, you sell the desk to a friend who has always loved it.
By picking up what would have otherwise been trash, putting a little work and TLC into it, and finding a new place for it, you gave it a whole new life. This anecdote illustrates the principle of value-add, a common strategy for investing in real estate.
So, What is Value-Add Real Estate?
Most people are probably familiar with the fix-and-flip method of buying and selling single-family homes from watching a show like Fixer Upper. In case you need a refresher, here’s how that works: You buy a house that needs some work, remodel it, then sell for a profit. You reap the monetary benefits of your hard work and eye for potential and the new owner gets a beautiful move-in ready home. It’s a win-win.
There is a similar process for value-add in multi-family real estate but on a much grander scale. In that case, instead of renovating a single-family home in a manner of months, you’d be renovating multiple units over a number of years. And since it’s a much larger project, you’ll be part of a group of investors funding the project, that’s where the syndication part comes in. So let’s talk a bit about that.
Real Estate Syndication
A real estate syndication is a group that comes together to invest in a real estate asset. Since many individual investors don’t have millions to invest in a multi-family property, a group of investors can pool their resources to purchase and renovate a property together by forming a syndication.
Most syndications have two kinds of partners, general and limited. The general partners are responsible for all of the planning and management of the asset and renovations, while the limited partners are passive investors and won’t be responsible for much more than providing some of the capital needed to purchase the asset.
Improvements That Add Value
Now that you’re familiar with a real estate syndication, what should you look for in a value-add property?
A property that could benefit from cosmetic improvements such as new appliances, fresh paint, and expert landscaping could be a great choice. Simple improvements like these can increase curb appeal and attract more highly qualified tenants, thus increasing the income for the property owners.
Improvements to value-add properties should accomplish two main goals: Overall improvements to the units and community, which has a positive impact on the tenants and increases the bottom line to benefit the investors. This way, both groups have something to gain in either investing in the property or remaining a tenant in a property that will be improved. Again, win-win. But what improvements will be the most beneficial for your property?
Let’s look at some examples.
Starting with improvements to individual units, there are quite a few things you could upgrade. for example:
- New appliances
- New countertops
- Fresh paint
- New flooring
- New cabinets
- New fixtures
While improving individual units will certainly add value, there are also things you can do to improve the property as a whole, such as:
- Sprucing up the exterior of the building with fresh paint
- Adding covered parking for tenants
- Increasing the sense of community by adding spaces like pools, gyms, playgrounds, or dog parks
You could even use this renovation period as an opportunity to increase the efficiency of the property by implementing some of the following:
- Reducing expenses
- Setting up a plan for shared cable and internet
- Taking advantage of green initiatives to decrease utility costs
Now that we’ve reviewed the basics of a fix-and-flip and understand real estate syndications, let’s look at the differences between single-family value-add and multi-family value add projects.
Renovating a single-family home is nothing like renovating multiple units. There are so many logistics to consider and questions arise around how you can make renovations while people are still living there. Which units do you renovate first? How many units can you work on at once?
Let’s say you have a multifamily property with 100 units and a 5% vacancy rate, meaning you have five empty units. That’s where you’d begin renovations – with the units that are already vacant.
When those renovations are complete, you can offer current tenants a place in one of the newly renovated units when their lease comes up for renewal. Many tenants will be happy to move to an updated unit, even at a higher rent.
When the current tenants relocate to the renovated units, you can start working on the units they’ve left vacant. Then repeat that process until all units have been upgraded.
Inevitably, some tenants will move out of the property during this process, so make sure to take that into account and plan for a higher vacancy rate during the renovation process.
Advantages of Investing in Value-Add Properties
Value-add projects can benefit everyone involved when done well. The improvements to the property make it a more comfortable place to live for tenants and more valuable to prospective buyers. But what makes value-add investing so attractive to investors?
Let’s look at a comparable real estate investment to help us understand the advantages of value-add.
Yield plays are real estate investments that bring in monthly cash flow from a stabilized asset like a rental property. The investors buy the property and keep it for that monthly cash flow and with the hope of making a profit on its sale in the future.
With a yield play investment, the property would be in good shape at the time of purchase and provide monthly cash flow through the rents collected. That cash flow is our yield and that is the sole purpose of this investment. There is no plan for renovation or improvement of the asset, just the yield, and hope for a larger profit in a sale.
Therefore with a yield play investment, investors maintain the property until a market increase when they can make a profit on the sale. However, the market may remain flat or experience a downturn before the property can be sold for profit. So, there is a risk of losing money in a yield play as well.
Yield Plays vs. Value-Adds
As you can see, there are significant differences between yield play investments and value-adds with the most obvious being the amount of labor that goes into a value add investment. Renovations and upgrades take time and money, and with that comes inherent risk.
However, there are a ton of potential advantages that come with value adds, since the investors call the shots. By planning and executing upgrades to the property to increase its value, the investors are taking an active role in improving their assets, rather than waiting for the market to increase their chance of making a profit. By choosing that active role, they are also giving themselves the opportunity to keep costs down, lower monthly expenses, and raise rents on the units in the property.
The improvements to the property increase the income and therefore the equity in the property because, unlike single-family homes, commercial property value depends on how much income is generated, not comparable homes. So, as an investor, you help decide how extensive you want those improvements to be depending on how much of a value and equity increase you think the improvements would provide.
In addition to everything mentioned above, you’re probably also wondering what returns you can expect to gain when you invest in a multi-family value-add.
There are two types of returns on a multi-family value-add investment, cash flow and profit from a sale. During the course of the value-add investment project, you can expect cash flow returns either monthly or quarterly, usually in the range of 8-10% per year. Then, when the property is eventually sold, you’ll get a share of the profits. If all goes well, that could be 40-60% of your original investment.
Sounds great, right? But before we get too excited, let’s take a look at the risks as well.
Risks and Disadvantages of Investing in a Multi-family Value-add
While a multi-family value-add can be a great investment, there are risks involved and things you should consider before moving forward. First, value-add real estate syndications are long-term investments that require a substantial investment to start (usually a minimum of $50,000) and don’t allow for recalling funds while the project is ongoing. Then there are a number of issues that could arise during the renovation period like not achieving target rents for updated units or renovation costs exceeding projections.
These risks can be worrisome, but there are quite a few things you can do to protect yourself and your investment.
Since the capital required to participate in a real estate syndication is not insignificant, the first thing you can do is make sure the money you plan to invest in this venture is truly available for it and you have savings in other accounts set aside for unexpected expenses or emergencies, Then once you’re sure you have the capital to invest, you can develop strategies to ensure your investment is a success such as:
- Follow a proven business model
- Choose a sponsor who prioritizes preserving your capital
- Make sure the total principal investment of the syndication includes the budget for renovations and other expenses
- Choose an experienced team to manage and execute your renovation project
By following these guidelines before and during your time investing in a multi-family value add project, you can keep your risk low and returns high.
Ready To Invest In A Value-Add Real Estate Syndication?
Now that you have an idea of what a value-add real estate syndication is and the basics of how it works, you’re ready to take action in support of your financial and lifestyle goals. We walked together through how real estate syndications compare to other types of real estate investments and looked at risks and potential returns.
Multi-family value-add investments can be a great way to earn a passive income, plus you have the ability to manage risk, even as a passive investor. If you’d like to learn more about how to invest in a multi-family value add with us, join the Great Venture Investors’ Club and keep an eye out here for more information on our upcoming investment opportunities.