Value-add real estate is a property that hasn’t reached its full potential yet. There are many reasons these properties can’t sell for what they’re really worth on the market, such as bad management, expensive repairs, a drop in demand for what they have to offer tenants, and so on.
Before you invest in a value-add property, you should know that they are usually a lot more work than a simple flip and require more knowledge than a simple flip.
But many people are making a lot of money with value-add investments.
In this guide, we’ll show you how to tell if a property with added value is a good investment.
What is a Value-Add Property?
“Value-add properties” must be fixed before they can reach their total value. Standard, or “core,” properties are less risky and give better returns than these. Properties in this category may have a number of common problems, such as maintenance that hasn’t been done, below-market occupancy, lease rates that are lower than the norm in the area, and facilities and equipment that aren’t up to par need to be fixed or replaced.
For a value-add property to give a good return on investment (ROI), investors must invest money, time, or both. Some common ways to improve value-add properties are to fix up the inside and outside, reorganize the management, do more marketing, or change how the property makes money.
These so-called “repositioning” efforts are meant to change the value of the building by bringing in more money by making capital improvements that make the building more appealing to tenants.
If an investor wants to buy value-add properties, they need to have a lot of tools. It’s important to know how a property looks physically, and having a background in construction or architecture is a big plus. Market analysis is also important because you can’t control most of the things that affect how much a property is worth. Understanding how to manage assets and generate and maintain income is also crucial.
Benefits of Value Add
The main advantage of value-add real estate investments is that their return on investment (ROI) could be higher than that of core or core-plus properties. Smart investors can find diamonds in the rough, put some money and work into them, and then either turn them around and sell them or keep them for better cash flow.
Investors can use their knowledge of real estate to generate more revenue with value-add projects than with projects that don’t have a value-add element.
Investors in value-add projects also get the benefits of buying commercial real estate in general, like the chance that the property will go up in value and a steady, long-term cash flow. Of course, value-add investments carry more risk than core or core-plus properties. We’ll talk more about this in the next section.
Risks of Value Add
Value-add investing is different from other real estate plays because it focuses on properties that need to be fixed up. It also uses more leverage (debt) than other real estate plays and makes money through construction and development projects.
Value-add investments have a lot more risk because of construction risk. Most of the time, the risk is higher when a property needs more work or repairs.
Less complicated projects like making the property bigger, replacing fixtures and building systems, or making cosmetic changes carry less risk than full renovations or conversions that change how the building is used. One way this strategy is used that you should be familiar with is when investors or developers turn old factories into loft apartments. This is called “adaptive reuse,” and projects that use this method have a lot more risk.
There are also risks if you decide to find new tenants or add to the number of people renting from you. Actions like raising rents or getting new tenants may turn out to be harder than expected, which can cause costs to go up and cash flow to go down.
Also, investments that add value may depend more on total returns than on shorter-term current yields. This is because price appreciation is often a big source of returns for projects that add value. In other words, while vacant units or spaces are being fixed up as part of a value-add deal, rents will likely go down during the construction and improvement phase.
Should You Use Value-Add?
Everyone can make value-add investments, but only certain types of investors do well with value-add property investments. You probably don’t want to begin your real estate investment with a project that increases value. Even though it’s possible that your first deal won’t hurt you or even make you a lot of money, it’s more likely that your project will go over budget, take longer to finish, and underperform as a result.
Remember that value-add real estate investments carry more risk than the traditional core and core-plus commercial real estate.
Most value-add projects are medium to high risk, so if you can’t handle that level of risk, you might not be a good fit for value-add.
It’s best to leave these projects to developers who know how to handle all the moving parts of value-add real estate investing. On the other hand, investors can make passive investments in value-add properties by using a real estate investment vehicle. This way, they don’t have to worry that their own experience will hurt the project. Whether or not value-add projects are right for you depends on how willing you are to take risks and how much you know about commercial real estate.
Advantages of Value Add in Terms of Tax
Compared to other popular investments like stocks, mutual funds, and bonds, investing in value-added real estate has many tax advantages. First of all, the depreciation schedule of a property lets investors claim several tax breaks as long as they own a share of the property.
The IRS sets the depreciation schedule at 27.5 years and lets investors deduct 1/27.5 of the depreciation from their yearly taxes. Property investors can also deduct the costs of repairs, utilities, and other costs that come with running and maintaining an investment property.
Internal Revenue Code Section 1.263A-1 says that if you borrow money to build something new or fix something up, you can add the interest you or your company pays on the loan to the property’s basis and depreciate it over 27.5 years, the same as standard commercial property. You can also add value-adding properties to a 1031 Exchange to put off paying taxes on capital gains. This lets you reinvest your profits each year without paying Uncle Sam until you cash out your investment.
Please keep in mind the obvious: anything on this website that seems to advise about accounting, the law, or investing does not. Please talk to a qualified professional in accounting, taxes, the law, or investing if you need help with those things.
In Conclusion
Like any other investment, adding value to real estate works well in some portfolios and not so well in others. Value-added properties have a higher risk/return profile than the core and core-plus properties, so people who don’t like taking risks shouldn’t buy them. Having said that, if you manage value-add investments well, they can give you great returns and big tax breaks compared to stocks, bonds, and other common investment vehicles.
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