Introduction:
There are numerous commercial real estate investing strategies. One of the more prevalent tactics is known as “value add.” While experienced investors commonly use this statement, it frequently confuses novices: is this method as simple as it appears, and how does an investor genuinely add value to a property? As a result, we’ll utilize this article to define a value-add real estate transaction.
Commercial Real Estate Investing, Passive Real Estate Investing
Commercial real estate (CRE) is a property used solely for commercial purposes or to offer a workspace, as opposed to residential real estate, which is utilized for living purposes. Most commercial real estate is leased to tenants for them to generate income. This vast real estate category can range from a single storefront to a large shopping mall.
Commercial real estate can take several forms. It could be whatever, from an office building to a duplex, as well as a restaurant or warehouse. Individuals, businesses, and corporations can profit from commercial real estate by leasing, owning, and reselling it.
Commercial real estate is divided into numerous areas, including office space, hotels and resorts, strip malls, restaurants, and healthcare facilities.
There are numerous commercial real estate investing strategies. One of the more prevalent tactics is known as “value add.” While experienced investors commonly use this statement, it frequently confuses novices: is this method as simple as it appears, and how does an investor genuinely add value to a property? As a result, we’ll utilize this article to define a value-add real estate transaction.
We’ll go through the following subjects in particular:
- Determining Commercial Real Estate Value
- Real Estate with an Added Value
- Last Thoughts
Determining Commercial Real Estate Value
Before adding value, investors must understand how value is determined. Appraisers in residential real estate analyze similar property sales – “comps” – in the market to assess the worth of your home. This strategy succeeds because of these dwellings’ relative regularity and sales volume.
This level of consistency and volume does not exist in commercial real estate. A large, mixed-use structure may be found in a community (e.g., a couple of retail spaces at ground level and 12 apartments on the top floors). Appraisers, using the comps approach, would need to discover a nearly identical property in the previously sold area – an extremely unusual scenario.
As a result, investors and appraisers have created a new approach to commercial real estate valuation. Rather than relying on sales comps, commercial real estate value is determined by the property’s income and a related market indicator. Specifically, parties determine value using a mathematical method known as the commercial value formula. This is how the formula works:
NOI ÷ Cap Rate = Property Value
NOI, or net operating income, is the difference between a property’s rental revenue and all running expenses. Please note that mortgage interest and depreciation are not operating expenses). Because NOI plays a role in the commercial value formula, this valuation strategy is also known as the income approach.
The capitalization rate, or cap rate, is conceptually equal to the return on an all-cash (i.e., unleveraged). For example, if you paid $1,000,000 for an apartment complex and made $50,000 in operating income, the cap rate would be 5%. Mathematically:
NOI ÷ Property Value = Cap Rate
As this rearranged formula shows, cap rates are determined by two interconnected factors: a property’s operating income and valuation. The cap rate is determined by the risk and stability of a property. If a property delivers consistent, reliable revenue, investors will pay a premium, increasing value and resulting in a lower cap rate. Unreliable revenue, on the other hand, increases the risk for investors, lowering the property’s value and increasing the cap rate. In practice, cap rates are determined by the local market, the type of property, and the tenants.
Real Estate with an Added Value
What exactly is value-add real estate?
Value-add investors try to take advantage of this commercial value formula. Value-add real estate agreements take existing properties and make changes to either A) enhance NOI, B) lower the cap rate, or C) both. As a result, the property’s value rises.
As an example, consider the $1,000,000 home mentioned above. Buying the property earns $50,000 in NOI, resulting in a 5% cap rate. As new owners, you replace the management firm and make some renovations to the common areas. These modifications result in higher rentals and lower operating costs, resulting in a new NOI of $60,000.
With the same cap rate, a $10,000 increase in NOI results in a $200,000 rise in property value ($60,000 / 5% = $1,200,000). Value-add investors can recoup their investment by selling the property or taking cash out through a refinance.
A range of value-add strategies is available to take advantage of the commercial value formula. Three of the most common are listed below.
1st Value-add Technique: Raise Rents
Returning to the commercial value formula, there are two methods to raise value mathematically: decrease the denominator (cap rate) or increase the numerator (NOI). Also, if you can raise rents while keeping running costs consistent, you will enhance the property’s NOI and, as a result, its value.
Many value-add investors put money into cosmetic enhancements to achieve this. Repainting a structure, upgrading landscaping, and re-flooring common areas are all examples of ways to improve the appearance and feel of a property. Furthermore, this advancement may justify charging hire fees.
Additionally, some investors may refurbish units. You will command higher rentals if you replace the 1980s or 1990s-era furnishings and appliances with modern ones. While these upgrades are costly, a well-analyzed agreement will increase value and justify the remodeling cost outlay.
Technique for Adding Value 2: Lower Operating Expenses
Along with raising rents, many value-add investors seek to increase NOI by lowering a property’s operational expenses. If it is less expensive to operate a property, the NOI and value will rise. Please note that tenant satisfaction is your number one goal and aggressively cutting costs will have detrimental effects. Therefore, when looking for efficiencies find an appropriate balance).
When a building is purchased, many value-add investors replace current property management businesses. This cost should be reduced if you can streamline and, where possible, automate organizational operations. If you include utilities in your rent, installing consumption monitoring devices can help you detect spikes (for example, from a running toilet) in real-time rather than receiving a large utility bill.
Regardless of technique, lowering a property’s operational expenses (while maintaining or increasing rents) will raise its value.
Value-add Technique 3: Improving Stability will Reduce the Cap Rate
The previous two strategies concentrated on the value formula’s numerator. Value-add investors concentrate on lowering the denominator – the cap rate. While the market generally determines local cap rates, investors can take action to reduce them.
Class A multifamily properties have historically been less risky and more stable than Class B or Class C properties. As a result, these prominent buildings typically attract lower cap rates and greater valuations. If a value-add investor’s renovations can move a property up a quality class, the cap rate should also fall.
Reduced tenant turnover improves a property’s stability and risk, resulting in a reduced cap rate. Suppose landlords take steps to prevent turnover (for example, requiring credit checks and income minimums for screening, rewarding multi-year leases, etc.). In that case, a building’s stability improves, and the cap rate falls.
Although value-add investing is not the only commercial real estate approach, it is one of the most popular – and effective. As a result, having a thorough understanding of this method will aid new investors in evaluating potential investments.
We’d love to discuss other real estate investing opportunities for your specific scenario!
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