What Does Value-Add Mean in Real Estate?

Key Takeaways

• Income generating properties with the potential to provide more attractive returns with a bit of work or operational changes are considered value-add properties.

• The success of a value-add strategy for real estate investors is predicated upon the property’s potential for revenue growth once the changes are implemented.

• Passive investors considering this approach would do well to partner with an experienced value-add sponsor, as opposed to trying to implement this tactic alone. 

Real estate investing can take a number of different forms, the most common of which is owning and renting commercial and multifamily real estate.  However, there are a number of other investment strategies to pursue in this regard, one of which is value-add real estate investing. This approach can hold considerable appeal for investors who have a higher tolerance for risk, are seeking a substantial upside and understand how improvements can increase the value of a property. 

Value-Add and The Real Estate Risk Spectrum

Those aforementioned alternative strategies occupy individual points along what is known as the real estate risk spectrum. They are (ranked in order of risk and return potential) Core, Core Plus, Value-Add and Opportunistic. 

Core investment properties tend to be modern Class A properties that are already in good condition, occupied by quality tenants and located in markets in which demand is high. Considered to be the safest of real estate investments, their closest stock market correlation would be cash flow-producing income investments. Conservative investors such as insurance companies and pension funds tend to favor Core properties.

Core Plus properties’ closest stock market parallel would be growth and income investments. They could be nice buildings located in areas that have yet to come into their own. Perhaps they are operating at less than full occupancy, or they could benefit from minor upgrades. In other words, they are nice buildings whose full potential has yet to be realized and as result they are returning lower rents than their potential allows. 

Value-Add properties are usually in need of physical and/or management improvements to unlock their full earning potential. These could vary in degrees ranging from light value-add to heavy value-add and could be commensurately capital intensive. This will be described in greater detail below.  

Opportunistic properties can be quite complicated and involve very long hold periods before returns can be realized from them. Most closely correlated to growth stock market investments, opportunistic properties entail the highest risk and hold the potential for the greatest returns. These include ground up developments and property conversions. 

What is a Value Add Property?

Income-generating properties with the potential to provide more attractive returns with a bit of work are considered value-add properties. They may suffer from too much deferred maintenance, poor management, or a lack of amenities that, once added, could improve their earning potential. 

Applying the necessary upgrades, changing the way the buildings are operated, or bringing them more up to date could attract tenants who are willing to pay more. This, in turn, could improve the net operating income of the building. In other words, the success of a value-add strategy for real estate investors is predicated upon the property’s potential for revenue growth once the changes are implemented.  

This strategy, while potentially quite lucrative, does entail more risk than investing in a Core property, which is considered to be already stabilized. After all, rehabilitating a building suffering from years of neglected maintenance can be quite costly. Passive investors considering this approach would do well to partner with an experienced value-add sponsor, as opposed to trying to implement this tactic alone. 

Examples of Real Estate Value-Add

Commercial real estate value-add efforts can be as simple as refreshing a building’s interiors, implementing common area improvements, or painting the exterior to improve curb appeal. At the other end of the spectrum, it could involve completely remodeling the apartments in a multifamily property or installing more energy-efficient heating systems in a medical office. Adding cold storage to an industrial space would also be considered a value-add. Again, the overriding goals are to improve the quality of tenants and/or lower operating expenses.

Light Value-Add vs Heavy Value-Add

Modest exterior upgrades, freshening paint, and/or replacing carpets and light fixtures are considered light value. Improving landscaping and refinishing parking lots can also fall under the heading of light value-add. Similarly, replacing or restructuring the property’s management team or revising leasing contracts to pass more expenses on to the tenant are considered light value-add as well.  Other examples of the approach include reworking marketing efforts to lower costs and offering temporary subsidies to attract more tenants.

Conversely, heavy value-add is considerably more involved. Generally, a heavy value-add property is one in need of larger-scale improvements, often both structurally and in terms of the way it operates. Structurally, this could mean completely gutting units and refurbishing them from a near clean sheet. It could also entail add-on as well as partial demolitions. Reskinning buildings can fall under this heading, as can reconfiguring a building to increase revenue-producing square footage.  

Value-Add Strategy Pros & Cons

While value-add projects can take some time to come to fruition, returns are usually higher than investing in stabilized cash flowing Core properties. Moreover, the value-add approach entails less risk than the Opportunistic stratagem. Investors with a five to seven year time horizon and moderately aggressive tolerance for risk may find the value-add approach worthwhile. 

On the other hand, economic conditions could deteriorate during that period. Or, the area in which the property is located could experience a change capable of diminishing the value of the investment. Given that the average economic cycle runs just over five years, a value-add investment could be at considerable risk, depending upon where in the economic cycle it is launched. 

Investing with an experienced partner possessing a solid track record of managing projects of this type — through a variety of economic conditions — can help mitigate this concern to a degree. Still, it’s important to bear in mind there are no certainties where any type of investment is concerned.

Another important consideration is investment diversification. Spreading investment capital over projects of varying lengths, locations and property types can help manage risks, as can investments in a variety of asset classes, both traditional and alternative.

Value-Add Investments and Portfolio Diversification

In addition to value-add investments, pursuing other types of opportunities can help preserve capital regardless of market trends or economic cycles. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

In addition to real estate, private equity, venture capital, digital assets, precious metals and collectibles are numbered among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Value-add real estate investing has the potential to deliver sizable returns, but careful management and paying close attention to the property’s fundamentals are paramount to achieving them. For this reason, it is advisable to approach this area with the assistance of well-capitalized and seasoned real estate sponsors. 

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.