What Are Value-Add Properties and How Do You Implement the Strategies?
Value-add properties offer opportunities for investors to increase their properties’ values through renovations, remodeling, operational streamlining, and identifying new income streams. Oftentimes, value-add, real estate opportunities are experiencing some level of deferred maintenance, inattentive or poor management, or just need a fresh pair of investors’ eyes to see the property’s potential.
Since commercial real estate is valued based on the Income Approach of property valuation - Net Operating Income divided by the market’s Capitalization (CAP) Rate, resulting in the Property Value (NOI/CAP Rate = Property Value) - increasing income and/or decreasing expenses will result in a higher NOI and therefore, property value.
For example, let’s take property A, which has an NOI of $500,000, and property B, which has an NOI of $525,000. Assuming the market CAP rate is 5%, Property A’s value is $10,000,000, and Property B’s value is $10,500,000 - a $25,000 difference in net income per year resulted in a half million dollar difference in value.
Multi-family is the darling of the commercial real estate world right now, and since most of my readers are familiar with this asset class, I’ll go into some examples of strategies that you can employ on value-add, multifamily properties. Most of these strategies will work across all asset-types, though, and they are by no means, all-encompassing. The only limit to how you can add value to your property is in your own thinking and imagination.
Renovations & Remodeling
First, let’s define renovation and remodeling. Renovating is the act of restoring something old, outdated, or damaged to new.. Remodeling is the act of transforming something to a new or updated use.
Interior renovations include things like repairs to units to bring them to newer condition, such as repainting, replacing flooring, kitchen cabinets, countertops, bathroom tiles, and bathroom fixtures. Modernizing an apartment unit after a tenant moves out allows the property owner to compete against the newer inventory on the market and to charge higher rents when compared to an older, outdated unit.
Exterior renovations include exterior repairs (new paint, resurfaced driveways and parking areas, dry rot repairs, etc.), building component repairs (HVAC units, water heaters, mailboxes, etc.) and cosmetic upgrades (new branding, updated landscaping, safer and more attractive lighting, etc.). Performing these renovations allow the property owner to better attract future tenants while also cutting future repair costs due to failing equipment.
Remodeling is where you can really let your imagination run wild. Some ideas to capitalize on are the addition of a laundry room where one doesn’t already exist, the addition of storage rooms for rent, the conversion of large one-bedroom units to two-bedroom units, the addition of ADUs, the addition of amenities to attract higher-paying tenants (e.g. package locker, dog run, rooftop deck, children’s play area, etc.), or the addition of air conditioning units in older buildings. While things like a laundry and storage rooms will immediately impact the bottom line, other items, similar to exterior renovations, are a means to attract better and higher-paying tenants.
Operational Streamlining
Before developing a strategy to streamline operations at a property, you have to do a deep-dive into its numbers - all income streams and all expenses - and you have to have an intimate knowledge of what is “normal”. When you’ve identified something out of the norm, whether it’s an income or expense line item, you’ll know that there is opportunity to streamline operations.
The lowest-hanging fruit is probably going to be below-market rents. Researching rental comps and understanding the value of each of your units when compared to similar units in the area will give you a sense of what you should be able to achieve for each unit. In a jurisdiction with rent control, your ability to get rents where they should be will either be regulated at the city or state level. Because of this, it’s important for you to understand what rent-increase limits are imposed in your jurisdiction as statutory regulations will greatly impact your future rent projections. Assuming you have a full understanding of these, creating value in this arena is as simple as increasing rents to market rates or by the highest, allowable amount at acquisition, then staying on top of your annual increase notices from there.
Similar to rents, understanding the market rates for storage, laundry, or other ancillary/amenity charges will assist in your evaluation of your value-add opportunity. Again, depending on the city you are in, you may or may not be restricted from increasing these rents (in San Francisco for example, if a parking space or storage space is rented with a unit, those amenities are rent-controlled as well), so it’s important to understand your specific market before you make any changes.
On the expense side, something many investors ignore when hoping to add value, it’s more of the same - understanding market rates for the services and contractors you employ. I’ll break this section down into a few subcategories:
Utilities (Gas & Electricity) - you may feel stuck with the public utility you have, but there are third party energy suppliers that you can purchase your gas or electricity from. They’ll often provide a savings when compared to your public utility, but keep an eye on your bill as they’ve been known to creep up after you’ve been signed up for a while.
Utilities (Water) - unlike energy utilities, there isn’t a third party that you can purchase your water from, so unless you have your own water source on your property, you are at the mercy of your provider’s rates. There are, however, upgrades you can make to reduce the amount of water usage at your property - these include low flow shower heads and faucets, low-flow toilets, locks for exterior spigots, and converting sprinkler systems to drip systems. In addition, it’s extremely important to monitor your water bills - issues like leaky plumbing fixtures will show up as spikes in your water usage, so catching them in a timely manner will prevent unwanted expense.
Utilities (Cable, Phone & Internet) - how many times have you signed up for a new internet service at their promo rate, only to realize that your bill almost doubled the second year? It happens in multifamily as well, but getting your rate dropped back down is usually as easy as calling your provider and asking them for the promo rate - I’ve found that they prefer to keep you as a customer than to lose you to someone else.
Contract Services - these include things like landscaping, janitorial, fire extinguisher and fire system maintenance, and elevator maintenance, among other things. Shopping around at each renewal period will ensure that you’re getting the best service for the best price. Oftentimes, the contracts that are incumbent to the property may be so much higher than market rates that you’ll be able to find significant cost savings immediately.
Physical Operations - while touring a property next time, pay closer attention to the smaller details and cross-reference them with the financials. In a poorly managed property, small things start to fall through the cracks, and the costs associated with these small items can start to add up. For example, imagine you’re touring a property, and you see a hole in the lobby drywall created by the front door’s doorknob. When studying the property’s financials, you also noticed that there were multiple payments to different vendors for drywall hole repairs and a doorknob replacement. After discussing with the listing agent, you determine that those repair costs are associated with the front door, and the easy and apparent fix is to install a door stop. Although this may seem like an elementary example, I see it all the time at mismanaged properties, and you can keep your expenses down by staying on top of the small stuff. Another example of a small adjustment you can make is changing out old, energy-inefficient light bulbs for energy-efficient LEDs. This may not make a big difference in a small building, but as you get up in building size, changing hundreds of bulbs can result in large, electricity cost-savings.
New Income Streams
This is the one that I have the most fun with, allowing the creative juices to flow. The name of the game here is to take an inventory of what your building has or doesn’t have, identify room for available options deploy, and implement ideas that will generate additional income.
Some examples include:
RUBS - which stands for Ratio Utility Billing System, allows you to charge utilities back to tenants if the units in your building aren’t individually metered. Depending on your jurisdiction, you may need to wait on the turnover of each tenancy to implement this, but it’s a great way to recuperate utility costs. It’s also a great way to encourage tenants to be more mindful of the resources they use.
Internet - instead of having each unit sign up for their own account, you can negotiate a rate with a provider for building-wide access with individual connections to each unit. You’ll usually be able to negotiate a lower, volume rate for becoming the sole account holder and administrator, which would allow you to charge the tenant the going market rate while collecting the difference.
Laundry rooms - do the units in your building have laundry hookups or machines in their units? If not, is there a common laundry room for your tenants to use? If no laundry facilities exist, installing one will help generate additional revenue and provide a convenience for your tenants.
Storage rooms - as units become smaller and cities become more densely packed, people are running out of room to store their things. This is why the self-storage market went gang-busters in the last decade. Finding room to build and rent out storage units will provide an additional revenue stream.
Community room rentals - the gig economy has allowed everyday people to earn extra income through apps like Airbnb and Swimply, so why can’t a multi-family owner/operator do the same. You can generate additional income by renting our your community room space to tenants or outsiders (assuming it’s safe and reasonable to do so; e.g. a large community with a detached community room). If you’re not willing or unable to rent to outside parties, providing this option to just your tenants can still create additional income.
Parking - almost 92% of American households have at least one car., and 37% have at least two. Again, as cities become more densely packed, it’s getting harder and harder to find parking. The guarantee of having an assigned space is a luxury many tenants will pay for.
ADUs - whether it’s in an unused portion of your lot, an old storage shed, or a parking area that isn’t feasible for use with the size of today’s cars, adding additional units to your building can be a great way to add a significant bump in income to your bottom line. Do be careful here, though - with today’s increasing construction costs, it’s important that you perform a thorough cost-benefit analysis to see if the work needed justifies the increase in value.
Concierge services - your ability to implement this one is dependent on the size of your property/community, but if the size and available staff allowed for it, providing services such as dog-walking, laundry wash-and-fold, vacation mail/package hold, etc. will positively impact your bottom line.
Tenant buyouts - a tenant buyout is an exchange of money for the tenant’s agreement to move out of a unit. This strategy can be employed to “get a unit back”. Oftentimes, and especially in rent-controlled jurisdictions (this includes all of California now) the subject unit will be significantly below market rent, and no legal means of increasing the rent will get the unit’s rent rate where it needs to be, so a property owner will buy their tenant out in order to get the unit back, perform necessary renovation work, and rent the unit at market rates. Although controversial to some, it’s important to note that negotiating a buyout with a tenant requires their agreement. Other common scenario where a buyout may make sense is when dealing with problem tenants; tenants that are a nuisance to their neighbors and/or landlord but are not breaking the law or may not warrant eviction action.
There are many more strategies you can employ to increase the net operating income at a value-add property, and they’ll often be property-specific, so it’s important to perform proper due diligence when evaluating the potential purchase of a building.
If this all sounds like too much work and isn’t something you’d even want to start to tackle, but you believe in real estate as an investment vehicle, reach out to us to find out how you can leverage our experience, network, and expertise, so you can benefit from these strategies without having to lift a finger.