If executed well by an investor, value-add investments can be one great way to give investors an opportunity to increase their properties annual income as well as value. This strategy is one in which an investor acquires a property with the intention of making some kind of improvement for financial gain. It is key to understand the costs involved with any permits, constructions work, and designs you may need. You must also have a strong understanding of the market… what they want and what they would pay for.
To take that first step of identifying a promising value-add property, you must first understand common methods of adding value to an asset. Here are some:
- Identify a property where tenants are paying below market rents. Investors will seek properties that have shorter term leases in place, providing them the chance to renegotiate lease terms with existing tenants or find a new tenant who will pay market rents. By bringing rents to market, an investor has now increased the income of the asset, improving its yield which will increase its value.
- Purchase a building with vacancies and tenant the empty spaces. Vacancies often result in lowering the value of a property; once the vacancy is re-tenanted and a lease is in place, the value of the property will increase, bringing more income. Remember though that when re-tenanting, a landlord must take into consideration TI (tenant improvement) costs.
- Bring in a corporate tenant. In every lease, there is a guarantor, and the stronger the guarantor, the safer the reliability is of that properties income. Therefore, a property that currently houses mom and pop tenants who are more subject to ebb and flow in their business can see its value improved if the investor instead brings in a stable corporate tenant. Bringing increased security to the deal immediately improves value.
- Extend the tenant’s existing leases. Often, having a longer lease (10 to 15 as opposed to 2-5 years) with a financially strong tenant brings up the value of a property because it provides more security in income to an investor and lending options open up. In this scenario, the landlord will most often need to offer something in return for the extended lease; however, in certain cases, a reduced rent with an extended lease can increase the value of the asset.
- Add square footage to an existing site, when permits allow. This can include adding more apartment buildings to a site or adding a freestanding building to the corner of a shopping center. By adding more square footage, an investor is able to bring in more tenants and increase the property’s revenue. Compare costs vs benefits in this case.
- Remodel existing sites and rebuild with an eye to what is in demand today. The details of this strategy can vary greatly depending on the site. Some examples include: increasing the ceiling height or adding loading docks in an industrial building; upgrading apartment units by installing hardwood floors and stainless-steel appliances; or, for retail units, investors can install glass windows, raise ceilings, or change the rules and allow for tenants to use signage. These are just a few adjustments that landlords can make; the principal here, regardless of how you choose to go about it, is to update the property to increase its value.
- Demolish sites and rebuild. Similar to the remodeling example, the goal of demolition and rebuilding is to maximize the space and bring in the highest possible revenue. Some buildings are so expensive or inconvenient to remodel that the investor is better off demolishing that property and rebuilding it with the specific plans of the tenants in mind.
- Improve parking. Regulations by your city require a specific number of parking spots per tenant, and the number may vary depending on the type of tenant. For example, in a retail strip, a restaurant will need extensive parking available while a dry cleaner site will need minimal. Revamp the property’s parking to accommodate higher paying tenants and allow for larger spaces. If the space permits, property owners can even consider installing lifts. The more customers at the property, the more revenue each tenant can bring in, allowing for a justification by tenants to pay higher rents, increasing the value in the property.
- Make the property more marketable! Entitlements, permits and plans, changing the zoning often help to make a property more marketable. Many developers only focus on that part of the business. Investors who are willing to put in more work on the right kind of site can increase their return. Each of these processes can be time consuming; however, if a site is ready for development, you saved a buyer time and that increases value and marketability.
The return on investment in value-add deals can be much higher than the return you would see when investing in stabilized assets. However, the risk can be higher because success is contingent on how well an investor understands the area, the market, and the costs of the kind of changes they plan to make to a property. A strong understanding of local demand and taste is critical for anyone hoping to succeed in value-add investing. Otherwise, precious time and resources could be wasted creating and modifying spaces that tenants aren’t interested in or that don’t improve the revenue and value of a property. Taking on a project in a secondary or declining market, for example, is a common pitfall. It can prove overall detrimental for an investor, especially in the presence of an economic downturn. With these tactics described above as your guide, take a hard look at your city, figure out what tenants are looking for, and find some promising properties to improve!
Read about another useful too: The Magic of Diversification and Why You Need It.
