In this lecture, we look at how the value-added investment strategy falls somewhere in between core and opportunistic strategies.
- The third investment strategy we're going to look at is called value added, and as you might be able to guess, it falls somewhere in between the opportunistic and core-investment strategies. It's a strategy that aims to balance risk with the rewards. So the key goal for a value-added investment strategy is to retain some potential for upside, but still have some initial cash flow.
These types of investments tend to also have low to moderate leverage, and they will have light to moderate renovations. You're not going to see value added doing some major, major renovations. Those would fall in the opportunistic category. So some value-added types of investments could be cosmetic-type of upgrading. So what some folks in the industry would call putting lipstick on a pig in order to try to achieve higher rents.
Or there may be something where there's an issue that is easy to fix that would increase occupancy. Or maybe an operating asset, for example, it could be a self-storage facility where the original owner is not very good at running a self-storage business. They're employing way too many folks. Their labor costs are high. They are spending way too much on frivolous marketing expenses, and you may have an expertise, or you know an expert who can come in, and take over, and operate at a much, much higher efficiency.
These are more value-added types of play. So other things involving slight expansions, or conversions, or mini-renovations, things that aren't building something completely from the ground up or doing a major, major fix up; those would be considered value added. And, typically, now depending on the type of investment or how much work you're putting in; the range for the value added will fall somewhere in between the core and opportunistic, and can be as low as the 10 to 12%, or it can go all the way to the high teens and even up to the 20s, really depending on how much work is done and what market you're in.
So if you're a residential investor, what would a value-add opportunity look like? Well, it wouldn't be a complete fix and flip to sell; it may be something where you're buying a rental that already has a tenant in there. Or you're buying a duplex where there's somebody renting already. But you see an opportunity to fix it up, and when the current tenant leaves, you're able to bring a new tenant in at a higher market rent. That would be a value-added residential play.
So let's, again, look at the risk/return profile. Now based on what you just heard, it's pretty easy to guess where the value-added investment strategy would fall. So in terms of the risk versus return, you're kind of somewhere in the middle. You are willing to take on some risk in order to have some potential for higher returns. In terms of sources of returns, again, value-added plays fall more in the middle, where you get some cash flow, but you're also doing some sort of value addition, and you're getting some asset appreciation.
So the returns in terms of its cash flow versus value addition would be somewhere in the middle. So let's look at a value-added example here in more detail. Let's say we are buying a very poorly-maintained, 50% lease apartment building. Something that right here, maybe it's a fourplex; and only two of them are rented. And it's kind of older, it doesn't look very good from the street, and you're not able to attract some of the tenants there because there are some issues with the unit.
The A/C doesn't work very well. You may need to replace the central air, something like that. But you still have two tenants in there, and they're actually paying rents so there's some income on this. So what you've got to do is you need to make the fixes or the renovations. Now this is where the upside would come from. After you make the fixes, at least the two new units, you'd be able to rent it at higher rates than you would have been able to rent it at before you made the renovations.
And as you hold the unit, and especially with the other two tenants moving out, you're able to now rent those at higher rents as well. Or even if they don't move out, but their lease agreement comes due, and it's time to renew, well, you can have them renew at a higher market rate. So quick recap. Value-added investment strategies are typically investment strategies that involve investing in something that already has some cash flow, but it's not realizing its full cash flow potential.
There's some opportunity, there's some work to add some value to the asset so that you can now then achieve its full cash flow potential. So there's some upside in addition to existing income. This is a good strategy for folks who want some upside but aren't willing to take the huge risks that typically come with opportunistic types of investments. And these are good investments for folks that don't wanta just invest in the safest, safest types of investments; and especially if they have a long horizon as well.
What you see with a lot of private investors is value-added plays also serves as kind of a stepping stone to go from doing straight, easy core type of rentals and going towards something that is more complicated and more exciting like fix and flips. They may do something in between, and a value-added rental play would be something in between before doing some sort of a full fixer-upper.
- Conducting market research
- The seven-stage investment process
- Due diligence: Validating and verifying your investment
- Financing and closing
- Exiting: Selling your investment
- Investment considerations and strategies
- Measuring returns
- How debt impacts your return
- Real estate analysis case studies