It is common to hear commercial real estate professionals describe themselves as “value-add” investors. We are value-add investors. But, what does this term actually mean?
In order to fully answer this question, it is first necessary to understand how a typical commercial property is valued.
Net Operating Income and Cap Rates
Unlike residential properties, which are valued on comparable sales, commercial properties are valued based on the amount of net operating income (NOI) that they produce.
Net operating income is calculated as a property’s gross income less it’s operating expenses. For example, if an office building produced $100,000 in gross rental income and had $50,000 in operating expenses, the resulting net operating income is $50,000.
When net operating income has been calculated, a property’s value can be estimated by applying a “cap rate” to it. Cap rate in commercial real estate is the estimated annual return on the property and it can be divided by the Net Operating Income to get an estimated value. Continuing the example above, net operating income of $50,000 divided by a cap rate of 7% implies an estimated value of $714,285.
The more net operating income a property produces, the more valuable it is. As such, a “value-add” investment strategy focuses on pursuing ways to increase it. Broadly, there are three ways to do this, increasing income, reducing expenses, or both.
Adding Value by Increasing Income
The most obvious way to add value is to increase the amount of gross income that a property produces while keeping expenses the same. There are a number of ways to accomplish this outcome:
- Increase the rent when existing leases come up for renewal
- Charge higher rents to new tenants
- Implement ancillary fees to increase non-rental income. This is particularly common in multifamily properties where fees are charged for things like late rent, parking, pets, laundry, vending, and applications.
- Add amenities to the property to justify higher rents. Typical amenities can include things like covered parking, fitness centers, security systems, high speed internet, picnic areas, and swimming pools.
- Renovate the property to improve its appearance, landscaping, and/or finishes. These improvements can drive rents higher.
- Lower the vacancy rate / increase the occupancy rate. If a property has vacant space or vacant units, one of the easiest ways to increase income is to lease it at current market rates.
While each of the strategies above takes a different approach, the goal for all of them is the same – to produce more income. If the expenses stay the same, net operating income will rise and so will the property’s value.
Adding Value by Decreasing Expenses
Income is only one side of the equation. Operating a commercial investment property on a day to day basis requires a significant amount of upkeep. Landscaping has to be maintained, property taxes have to be paid, and air conditioning units need to be fixed. There is a cost associated with all of these activities and another way to add value is to minimize them to the extent possible. Opportunities for reducing expenses include things like:
- Renegotiating service contracts. Expenses like landscaping, maintenance, and property management typically run on multi-year service contracts. When they come up for renewal, prices can be renegotiated in an effort to save money.
- Switch vendors. If one vendor is not willing to lower their price, it is always possible to find a new one at a better price.
- Eliminate Waste. Often expense line items like “General & Admin” contain a lot of wasteful spending. Implementing new procedures and requiring approval for expenses above a certain level can reduce or eliminate it.
- Challenge the Property Tax Assessment. If it appears the property’s tax assessed value is determined to be too high, it can be challenged. This is particularly relevant in market downturns. If the challenge is successful, it can result in significant cost savings.
- Insource. If there are management activities that can be performed by the owner, they can be insourced. For example, we have our own property management team, which can result in significant savings to our portfolio properties.
Successful expense reduction strategies send the cost savings directly to the property’s bottom line.
Adding Value By Increasing Income and Decreasing Expenses
The holy grail of value-add real estate investing is to increase income and decrease expenses at the same time. Doing so can “force” a property’s value to appreciate outside of market conditions. To illustrate this point, consider the following example. Suppose an investor purchases a shopping center and spends 18 months adding value to the property. Income goes up and expenses go down as shown in the table below:
At a 7% capitalization rate, the net result of the changes is an $2.45M increase in the property’s value, outside of market forces. This sort of increase can be a major driver of commercial property values and can add up to significant profits for investors. However, this strategy is not without risk.
Value-Add Risks
Pursuit of a value-add strategy comes with with two material risks:
- Execution Risk: A value-add strategy is great in theory, but it takes a significant amount of work to execute. This risk is particularly acute when major renovations are involved. They need to stay on budget and on time to keep the plan on track.
- Market Risk: A value add strategy hinges achieving certain rents. But, in the time it takes to implement the value-add plan, market rents can change, threatening to derail the projected returns.
To mitigate these risks, it is important that investors perform a significant amount of due diligence on the property, the market, and the assumptions driving the value-add plan. If it is successfully executed, the value-add property can realize significant increases in its cash flow, market value, and investor returns.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
