Achieving above average returns with any type of investing boils down to two things: 1) price and 2) timing.
Typically, these go hand in hand. Sometimes, though, the market is already expensive so finding value turns on identifying assets that are undervalued relative to their potential value.
Assets that are below market value often need repairs. Adding value in the form of renovations, amenities, and other services are the keys to unlocking that value and turning an underperforming asset into an outperforming one. In this blog, I’ll identify the 5 key points to consider for value-add deals.
You’ve heard it a 1,000 times: location, location, location. This old adage is critical to any kind of real estate investing. In particular, though, even average assets can become gems if they are in the right location. For multifamily properties, investors should pay particular attention to the surrounding area to see what it supports in terms of income and growth. For example, investors should evaluate the quality of the schools in the area and make sure the property is within close vicinity to retail shopping, including a major supermarket. Investors may also want to evaluate median income to get a sense of demographic trends. Finally, consider what a developer might replace the property with if it were to be demolished. Does the asset fit in the neighborhood?
The property’s condition is probably the most important consideration because the expenses that are necessary to improve the property will dictate your cost basis and thus, ultimately determine the return on the investment. It is vital that before you purchase any real estate, you thoroughly inspect it and hire a third party to inspect it. The obvious items should be at the top of your inspection punch list, such as the roof, floors, walls, electrical, and other structural issues. The age of the property is going to dictate life expectancy of many of the property’s components, as older properties tend to require more maintenance than newer ones. Physically inspecting the property yourself will enable you to test your senses, allowing you to smell and listen to the property to detect any strange odors or noises. You should also have an understanding as to any use restrictions or other covenants that might affect the use and enjoyment of the property. Similarly, you should be aware of any open permitting issues, as well as any code violations or other clouds on title. These issues can be determined through a title, lien, and open permit search.
Once you’ve inspected it, you can determine what kind of improvements will be necessary to create a value-added situation. In some cases, just a fresh coat of paint and some minor upgrades are necessary to support an upward bump in rents. Typically, though, if you’re buying really cheap it means that the property needs a major overhaul, with new kitchens, appliances, bathrooms, roof, etc. For commercial properties like small shopping centers, you should build into your proforma plenty of tenant improvement allowance to be able to attract national tenants or franchises of major brands. The property’s purchase price, therefore, should reconcile with the amount of improvements necessary.
Just because a property is located in a great part of town and is in good condition, that doesn’t necessarily make it a good buy if the returns are undermarket. Returns can be measured by the Cap Rate, which is the NOI divided by the purchase price. Cap rates vary among asset class and geography, so you should be sure to understand the market before you start looking at properties. If you are expecting to find 10% cap rates when all other comparable assets are trading in the 6-7% range, then you may have set unrealistic expectations for yourself. Engaging a real estate advisor is a great way to get an understanding of the market and help with identifying acquisition targets.
Clearly, there is a law of diminishing returns when it comes to property improvement, meaning at some point, no matter how nice or high end the property, the rents will be capped. Getting an above average return requires careful evaluation to limit the investment necessary to improve the property to generate the maximum return. For example, it would not make much financial sense to sink a lot of improvement costs into a property that already has rents in the upper tier relative to comparable properties. Ultimately, you need to factor in what rents will be post-renovation to determine whether you’ll have a healthy return on your money. If you plan on borrowing a portion of the purchase price, then you will need to understand debt service coverage ratios and how a lender will look at that ratio to determine viability. Stated differently, will the income support the debt and provide you with a reasonable rate of return?