- A value-add investment strategy seeks to acquire a property at a discount to its replacement value and implement a program of activities designed to increase the property’s Net Operating Income and thus its market value.
- Net Operating Income is calculated as a property’s Gross Income less its Operating Expenses. To that end, value-add activities seek to increase income, decrease expenses, or both.
- Examples of value add strategies include increasing rents, extending leases, implementing ancillary fees, insourcing property management, and challenging a property’s tax assessed value. While the method may differ, the target result for all of these is increased Net Operating Income.
At First National Realty Partners, we pursue a value-add investment strategy. This means that we intentionally seek out well-located properties that we can acquire at a favorable price—then, once acquired, we implement our proven value-add program to improve both the property’s condition and price. Historically, this strategy has been very successful, but it can be difficult to execute and requires years of experience to implement correctly.
In order to understand how our value-add program works, it is first necessary to review how commercial properties are valued.
Commercial Property Valuation
Simply, commercial real estate (CRE) is valued based on the amount of Net Operating Income (NOI) that it produces. Net Operating Income is calculated as a property’s Gross Income less its Operating Expenses.
Gross income is derived from a property’s rents, interest income, and ancillary fees for things like parking or pet rent.
Operating expenses are associated with the cost of running the property on a day-to-day basis. Typically, they include things such as property taxes, insurance, maintenance, utilities, and property management.
Suppose that an office building has Gross Income of $1,000,000 and Operating Expenses of $500,000. The resulting Net Operating Income is $500,000. When a market based capitalization rate or “cap rate” for short is applied to NOI, the value can be estimated. Assuming a cap rate of 7%, a property that produces $500,000 in NOI would be worth an estimated $7.14M ($500,000 / 7%). If NOI were to improve to $550,000, the same 7% real estate cap rate would imply a value of $7.85M.
As such, the central tenet of any value-add program is to increase the amount of Net Operating Income that the property produces.
How to Improve NOI
There are a number of different ways that a property’s NOI can be improved over the planned investment holding period, but they are all based on an attempt to increase income, decrease expenses, or both.
The two most obvious ways to increase income are to charge higher rents or to increase occupancy by signing leases for vacant spaces—but these aren’t the only ways. Other options include charging fees for rental applications (as in a multifamily property), charging rent for parking spaces, converting unused space into additional leasable space, or adding space on the premises that can be leased out. No matter the action, the goal is to increase income.
Cutting expenses can be a bit trickier because this action needs to be completed without affecting the tenant’s experience or the responsible upkeep of the property. For example, a retail shopping center should always be welcome and appealing to potential shoppers so it would be unwise to skimp on landscaping or maintenance, lest shoppers be turned away. Potential expense reduction strategies include things like: insourcing property management activities, challenging the tax assessed value, reducing advertising spend, investing in software and technology to drive cost efficiencies, or implementing a RUBs utilities system that bills the cost of utilities back to the tenants.
Ideally, real estate investors working with value-add properties can do both. If they are able to do so successfully, cash flow and NOI can improve dramatically, resulting in rising property values and a potentially profitable real estate investment. But, of course, this is easier said than done. Among the major factors in the success of our value-add program are our decades’ worth of experience and our industry relationships, both of which can be leveraged to accelerate NOI increases.
How Our Relationships Enhance the Value Add Program
Like any industry, commercial real estate investment is about relationships at its core. This point is particularly relevant when trying to add value to our properties. The following bullet points outline a the many ways our longstanding relationships enhance our value add program:
- Leasing: If we acquire a property that has a significant amount of vacant space, we can immediately leverage our relationships with regional and national companies to find new tenants and/or higher quality tenants. In fact, we are in frequent communication with these types of companies and usually have a general idea of the asset class and real estate markets in which they are looking for space. In a best case scenario, we are able to obtain a verbal agreement to lease space before we even close on the purchase, which allows us to increase income (and decrease the vacancy rate) rapidly after closing.
- Lease Extensions: When we acquire a property that has a large anchor tenant, it is common that we have a relationship with someone in their leasing department. We can leverage these relationships to extend or renegotiate leases with terms that are more favorable for the property. For example, if the tenant has two years remaining on their lease, we could work with them to get a 5-year extension, which could immediately increase the property’s value.
- Management: Managing a commercial real estate property on a day-to-day basis requires a significant number of vendor relationships for things like maintenance, landscaping, and repairs. Due to our size, scale, and history, we can leverage these relationships to drive pricing down for these projects and improve NOI in the process.
- Financing: Our long-standing lending relationships allow us to obtain preferential pricing for major physical improvement projects. Once complete, these projects drive higher rents and increase NOI.
- Sales: Over a long period of time, we have built a tremendous network of relationships with brokers and investors. When it comes time to sell a property, we can minimize sales and marketing expenses by leveraging these relationships to find a buyer.
- Brokers: Acquiring a property at a purchase price that provides a discount to a property’s replacement value is one of the keys to our value-add strategy. We can do this because we have a wide network of broker relationships from which we can cherry pick the best real estate deals that have the best chance for a high rate of return.
Ideally, we are able to leverage our relationships in all of these spaces to execute our business plan to improve NOI and drive higher returns for our investors.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our real estate investing opportunities, including qualifying opportunity zone investments, contact us at (800) 605-4966 or email@example.com for more information.
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