What You Should know before you invest.
If you’re interested in investing in commercial real estate, you can choose from a range of investment strategies, each with a unique risk-reward profile. Here we’ll take a closer look at value-add commercial real estate strategies, covering the key points you need to know before investing.
What is value-add commercial real estate investing?
When pursuing a value-add approach, sponsors aim to generate returns by proactively enhancing the value of a commercial real estate asset and increasing its cash flow during the holding period. Sponsors can apply a value-add strategy to a variety of property types—that said, it’s particularly popular with multifamily assets.
When looking to make a value-add investment, many sponsors seek out locations with strong rental growth rates, then identify assets that haven’t, for whatever reason, kept up with the recent growth, creating an opportunity for the sponsor to make improvements.
In short, the plan is to buy the asset and fix it up. This enables the sponsor to collect higher rents, thereby boosting the asset value and paving the way to a compelling return. It’s all about seeing the potential—then maximizing it.
Techniques to add value include:
- Physical improvements and renovations – Sponsors can reconfigure spaces, modernize interiors, resolve deferred maintenance, upgrade common areas, and refresh landscaping. Changes can range from minor enhancements to significant repositioning.
- Optimize operational expenses – Sponsors can increase net operating income by completing proactive maintenance, installing energy-efficient technology, and re-pricing contracts for marketing and maintenance.
- Improve asset management – Better management practices can help sponsors implement lease-up strategies, increase revenue, set optimal pricing, and forecast opportunities.
An example of value-add commercial real estate investing
At Caliber, we often pursue value add strategies for our assets, aiming to increase rents, bring down operating costs, and enhance the value of a property to generate attractive returns for our investors.
Let’s take Treehouse Apartments in central Tucson as an example. This 167-unit property was acquired by Caliber in April 2014 for approximately $4.8 million, roughly 70% below its replacement cost. With a renovation budget of more than $7.8 million, we converted the property from a Class C “workforce” property to a Class A type property.
The property is three miles from the University of Arizona and Banner Health Hospital, and five miles from downtown Tucson, which is near the Catalina Foothills recreation area and offers convenient proximity to a variety of retail, dining, and entertainment amenities. Tucson is the second most populated city in Arizona behind Phoenix and has benefited from the recent emigration of people from other more expensive U.S. cities seeking a lower cost of living and high quality of life. Tucson boasts temperate year-round weather, access to major transportation hubs, and employment opportunities.
Renovations were completed in July 2017 and included new cabinets and countertops, the addition of in-unit washers and dryers, and improvements to community amenities, such as a pool with fire features and BBQ as well as a clubhouse complete with flat-screen TVs and a full kitchen.
Caliber sold Treehouse Apartments for $23 million in February 2021. Caliber held the asset at a 10% cap rate on stabilized cost and subsequently sold it at an exit cap rate of 5%. As a Class C property, average rental rates were approximately $592 per month. After the renovation, average rental rates climbed to $975 per month.
How do value-add commercial real estate strategies differ from core and opportunistic?
Core real estate investments represent the most conservative blend of risk and return. Core properties tend to be well-built, located in great areas, have few deferred maintenance requirements, and are already filled with high-quality tenants on long-term leases.
Opportunistic investments are on the other end of the risk-return spectrum. Opportunistic projects can include developing something from scratch (ground-up development), repurposing a building from one use to another (adaptive reuse), and winning entitlements for raw land. Given the work and time required to take on these projects, investors can expect to see a high degree of leverage and risk. For these risks, sponsors aim to compensate investors with significant returns.
Value-add real estate strategies fall somewhere in the middle. The investment profile typically carries more risk than core, but is less than opportunistic. Accordingly, target returns for value-add projects are usually somewhere in between the ranges for core and opportunistic.
What are the benefits of value-add commercial real estate strategies?
For many investors, the key benefit of a value-add strategy is the opportunity to potentially earn a greater return than in a core real estate strategy. By proactively working to increase the net income generated by a given property, value-add sponsors are positioned to deliver greater returns than those available in a core strategy based on stabilized, in-place income and gradual capital appreciation.
What are the risks of value-add commercial real estate strategies?
While fixing up a property can potentially boost its value, it also creates risk. Curing deferred maintenance, for example, can provide a meaningful lift to a property’s value—but something like overhauling an aged HVAC system can also take more time and money than anticipated. Projects may not pan out as planned.
3 things to consider before you invest
Before committing to a value-add commercial real estate investment, it’s wise to consult your team of financial and tax professionals to examine the following:
- In general, what role does commercial real estate play in your portfolio? You’ll need to complete a thorough review of your existing portfolio across all asset classes, considering your investment time horizon, investment goals, and risk tolerance. From here, you can establish a framework for allocations to real estate product types, asset types, and strategies, such as value add.
- Within the value-add category, what investments are the best fit for you? The value-add category spans a range of investments, with some carrying more risk and potential return than others. Each investor must decide whether an investment’s potential return is appealing within the context of its risks. Some characteristics to analyze include:
- Market fundamentals – What is the outlook for the location and asset type? For example, a property in a lackluster suburban location that’s exposed to cyclical fluctuations carries more risk than an asset supported by long-term demand drivers in a location with sustainable job growth.
- Project scope – What is the sponsor’s business plan? For example, a project that aims to complete cosmetic upgrades to 25% of the units in a slightly outdated apartment complex is potentially less risky than one targeting major electrical and plumbing changes in every unit of an aged building.
- What is the sponsor’s experience with value-add investments? Track record, organizational structure, and experience are especially critical for success in the value-add arena, given the hands-on role played by sponsors.
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Caliber – the Wealth Development Company – is a middle-market alternative asset manager and fund sponsor with approximately $2 billion in assets under management and development. The Company sponsors private funds, private syndications, as well as externally managed real estate investment trusts (REITs). It conducts substantially all business through CaliberCos, Inc., a vertically integrated asset manager delivering services which include capital formation and management, real estate development, construction management, acquisitions and sales. Caliber delivers a full suite of alternative investments to a $4 trillion market that includes high net worth, accredited and qualified investors, as well as family offices and smaller institutions. This strategy allows the Company to opportunistically compete in an evolving middle-market arena for alternative investments. Additional information can be found at CaliberCo.com and CaliberFunds.co.
Click here to see Caliber’s current property portfolio.
If you would like to speak to someone about diversifying your retirement accounts, contact us at firstname.lastname@example.org or call (480) 295-7600 to schedule a call with a member of our Wealth Development Team.
If you would like to learn more about Opportunity Zone Investing, Caliber has put together a special guide that cuts through the myths and misconceptions and outlines the benefits, the risks, and the upcoming deadlines you must know to be able to participate. Get access to the guide here.
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.