This article is part of a series to offer some more context around each strategy – stabilization, value-add, new construction, and master-planned development. We’ll summarize the general business plan for each, discuss the opportunities and risks, and define the investor profile that may be suitable for each strategy. This article focuses on the Value-Add strategy.
HGTV hit a homerun with their hit reality show ‘Fixer-Upper.’ The show follows the husband-and-wife team, Chip and Joanna Gaines, as they help homebuyers locate and renovate ‘the worst house in the best neighborhood.’ The strategy is straightforward: acquire the home at a deep discount to the other homes around it, then use the remaining budget to finance renovations. The renovations and new family bring the home’s value in line with the rest of the neighborhood. It’s been a winner for the Gaines’ family (and HGTV) as they grow their Magnolia empire.
While Caliber’s focus is on commercial real estate, the essentials of the ‘Fixer-Upper’ strategy is the same: find an under-utilized property in a market with strong fundamentals, then raise capital to renovate to attract a key tenant. Once the tenant has been secured, sell the property, and use the proceeds to pay back our investors. It’s a great approach for investors looking to grow their retirement portfolios with less risk than a new build or land deal.
Let’s take a deeper dive into how the value-add business plan usually looks.
Value-Add Strategies in Real Estate Investing
Find an under-utilized property
Under-utilized means the property isn’t being used to its full potential. Something needs to be changed to bring it back in line with the rest of the neighborhood or market. Making those changes is where we capture the added value for investors. The opportunity to create value generally falls into three categories: physical, operational, or structural.
Physical value means the property’s physical characteristics need to be improved. That could be as major as renovating a lobby or changing the exterior design to updating the furniture, fixtures, or equipment. These types of improvements should attract a new tenant at a higher rate, at which point, the property will start throwing off cash. Then, at that point, we can look to sell.
Structural value refers to the organization of the property. It can take a lot of money to acquire and manage commercial real estate, so most commercial properties have multiple partnerships and complex funding structures. We can create structural value for our investors by restructuring overleveraged properties or resolving partnership issues. The property itself may be physically outstanding, but the organization underpinning the property could present opportunities.
Operational value means addressing issues with the property management team, specifically related to the property’s financial performance. For example, we can unlock operational value by identifying properties or property types with high costs we know how to reduce or eliminate. Cutting costs while boosting rent means a higher margin, which can improve the building’s final sale price and generate higher cash flow during the hold period.
These three areas of value are not mutually exclusive.
It’s common for one property to have all three as part of its business plan! For instance, it may be that we learned that a property slated for renovations is about to come on the market because the partners had a falling out. We can pick up the property (ideally before it hits the market), address the partnership issues, then renovate the property.
Once the renovations are complete, we’ll install a property management team, then put the property back up for sale. After the property closes, we tally everything up and distribute the final proceeds to our investors. The whole process can take anywhere from five to seven years.
Look for strong fundamentals in a value-add real estate investing strategy
Fundamentals refer to the property’s characteristics both tangible and intangible.
Tangible fundamentals include things like the property’s construction quality and the condition of its furniture, fixtures, and equipment (like HVAC units), as well as its physical location and surroundings.
Intangible fundamentals include the market’s trends in pricing (rising or falling), demographics (getting younger or growing older), and development (competitive or idle). A property is a good value-add candidate if the intangible fundamentals imply a market with a lot of potential in the next few years, even if the tangible fundamentals need work.
Once the work is done to identify a good value-add candidate, we’ll package that together and present the plan for investors to consider. Commonly, we’ll bundle several value-add properties into one fund.
The fund approach helps diversify the risk that investing everything into just one property carries. Next, we’ll lay out the profile of the properties we’re seeking to acquire for the fund, how much in total capital we need, and the potential returns you could enjoy for participating in this venture.
Secure a key tenant
The value-add strategy depends on attracting or retaining key tenants at higher rents to potentially generate higher profits for our investors. Unless the key tenant has already agreed to stay through the renovations, we’ll need to secure a new tenant. That means leaning on our brokerage leasing team to attract new tenants through marketing efforts and lease negotiation. They play a big role in boosting the final value of the property.
The last step of the value-add strategy is to sell the property and pass the proceeds to our investors (and cover the renovation costs). The final sale price is where most of the value comes from in a value-add deal.
What are the risks in a value-add strategy?
A deterioration in economic conditions is the principal risk to any value-add strategy’s success, otherwise known as ‘economic cycle risk.’ The average economic cycle lasts 64.2 months (just over five years); it typically takes between five and seven years for a value-add strategy to run its full course. So, the risk is that you invest in a value-add strategy just in time for the next recession.
Can economic cycle risk be mitigated? Risk cannot be fully eliminated, but it can potentially be mitigated through prudent portfolio construction. For example, diversifying amongst project length, business plan, geographic location, or property type can potentially reduce economic cycle risk.
It also helps to invest with a partner who has a track record of executing value-add strategies and has managed investor capital through a recession. At last count, value-add represents over 60% of Caliber’s property portfolio, and we now have two recessions under our belts.
Click to listen to Caliber’s CEO Chris Loeffler discuss how Caliber managed the business through the pandemic-induced recession.
Who is a value-add strategy right for?
Value-add deals take some time to put together and execute, but they can be well worth the wait. Returns are historically higher than stabilized cash-flowing properties, without as much risk as new construction projects or land deals.
Value-add investors should expect to see most of their return on invested capital following the sale of the property. So, it’s a strategy that’s best suited for someone with a time horizon between five and seven years with a moderately aggressive risk tolerance.
Learn About Caliber. Check Out Our Investment Funds Today
Our story is rooted in a set of investment principles that are now the company’s foundation. These principles were created naturally during our first formal year of operations, raising $18 million from investor-partners and buying, renovating, and selling over 150 single-family homes in 2009.
We offer multiple investment solutions from monthly income to aggressive growth, while also serving as one of the premier qualified Opportunity Zone Fund sponsors in Southwestern, USA.
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With Caliber, all our investments are structured so you profit first. Additionally, we’re an expert on middle-market investments in the Southwest & Mountain West regions of the U.S.—focusing on Arizona, Colorado, Idaho, Nevada, Utah and Texas. With years of experience in this market, we have specialized access to numerous unique groups, politicians, and local businesses that potentially create better processes and greater deal flows for our investors.
As an investor, you can count on Caliber’s long-term track record, our mission of communication and transparency, and expertise in real-estate investment practices to help you potentially grow your wealth.
Now is the time to build your wealth and transform communities today. Contact us at email@example.com to learn more about your investment opportunities today.