The goal of every value-added investor is to create a stabilized property. Value-added investing provides some of the greatest wealth-building opportunities in real estate. This type of investing also creates the greatest losses for real estate owners and investors. The one crucial component that is common to all value-added investments is how to tell a good deal from a bad deal. This lesson will provide you with key metrics to quickly and easily tell the difference between a good deal and a bad one.
In value added real estate, the asset is not ready for sale or permanent financing because the asset is not yet stabilized. There is a “bet” that value can be increased by increasing the NOI. This means that an investment within the property is needed so the property earns more income. By investing money into the property, a greater return is made! With value added properties, the value added loan is typically higher leverage than the stabilized loan, and the value added loan typically is a higher rate than a stabilized loan. The reason behind these features is because the risk is greater since there are more unknowns than in stabilized properties.
In value added properties, the investor analyzes the potential of a property. Investors buy the property for a price that is based on the value creation that they think they can achieve. This makes calculating the initial acquisition price more difficult. Investors must think about the following key items in value-added investing:
- Current NOI
- Project or future stabilized NOI
- Cost to improve the property
- Occupancy (current and at stabilization)
- Lease rate (current and after improvements are completed)
- Bridge loan financing during the value-enhancement phase (also known as interim financing)
- Loan-to-value (LTV) and debt service coverage (DSC) metrics for a take-out loan or a permanent loan, after the property is stabilized
- Time required to complete the property improvements
With value added properties, the investor’s goal is to increase the NOI and achieve an increased, stabilized NOI. Value added investing allows for the opportunity to hit the real estate grand slam, which encompasses the following:
- Invest in a property
- Improve it
- Refinance out all of the equity
- Own a cash flowing asset with no equity investment
In a value-added transaction, the investor looks at what the property could be, whereas in a stabilized transaction, the investor looks at what the property is today. A value-added transaction always include a plan for how to make the property better and more valuable. Successful value added real estate investing is one of the greatest wealth builders available. Below is a sample transaction for a value added property:
For all value added transactions, remember the following:
- The investor/lender is analyzing what the property could be, not what it is now!
- The investor has a story or a plan on how to make the asset better.
- The exit strategy for the interim or bridge loan is a refinance to a permanent loan or a sale.
- Upon stabilization, the investor has the opportunity to be “cashed out” and create wealth.
The key to analyzing the market is how the perspective rents and occupancy compare to the current market. There are three main types of transactions. The first is a Conservative Transaction. With this transaction, pro forma rents and occupancy are below the current market. This profile provides the most upside to the investor. The second is Base Case Transaction. Pro forma rents are occupancy are right at market. These are good transactions, but have the potential risk of market deterioration. The final type is Pioneering Transaction. Pro forma rents and occupancy are above market, and the transaction needs these above-market metrics to reach its business plan. The investor should be well compensated for these transactions.
In all value added investments, the investor is making a bet that good things will happen for the asset. “Good things” means increasing the NOI. The first step in value added underwriting is to understand the basic NOI numbers:
- Current NOI: What is the as-is NOI?
- Stabilized NOI: What is the NOI after all improvements are made and after all repositioning is complete?
- The NOI delta or change: Every good value added investment has a significant change in the NOI; from current to stabilized. Otherwise, no value is being added.
As a rule, there are only two ways to increase NOI: Increase Revenues and Decrease Expenses or Revenue Events and Expense Events.
The easiest and most common way to increase NOI is by increasing the property’s gross revenue. There are many revenue events: reasons why and ways in which the gross revenue can increase. The following events are the most common:
- Re-tenanting the Asset: This is considered an upgrade in the quality of the asset. These upgrades include increasing occupancy, the lease rate, lease term, and tenant credit.
- Rehabilitating the Asset: This typically involves capital improvements. Rehabilitation (rehab) of the physical asset should result in one or more of the following:
- Increasing Occupancy: More tenants
- Increasing Lease Rates: More money
- Increasing Lease Terms: Longer leases
- Increasing Tenant Credit: Better tenants
- Repositioning the Asset: This is changing the asset’s use and can include the following:
- Adding on to the existing asset and keeping its existing use (new construction)
- Changing the asset’s use (e.g. hotel to multifamily)
- Rolling Existing Leases: This means changing the tenant profile. One such way to change the profile is to change the tenant mix and achieve higher lease rates, longer-term leases, or higher quality tenants. The second option occurs when current market conditions are better than they were at the time the existing leases were negotiated, so investors “make a bet” they can increase rates without making any material improvements to the building.
- Submarket Story: This might indicate that “a rising tide lifts all boats,” meaning that something good is happening around the asset. This could include new infrastructure (e.g. roads), new employment centers (e.g. hospitals, large retail centers), and major private projects (e.g. a new mall).
Other than a revenue event, the only other way to increase NOI is to decrease expenses. This approach is more difficult, unless the property is clearly mismanaged or in some disarray. Most expenses are fixed and cannot be materially decreased. The following are the most common expense events:
- Taxes: The operator typically cannot decrease taxes. In fact, in most value added transactions, taxes are likely to increase.
- Insurance: The operator can decrease insurance only through efficiency, if he or she owns other properties, or by pooling the property with other assets.
- Maintenance Costs: The property must be properly maintained, and it is very difficult to keep up quality while decreasing maintenance costs.
- Management Costs: Unless the operator is going to self-manage, management costs do not vary much. They typically run at 3 to 4 percent of gross revenues.
An important reminder is to beware of the bad operator! Many new investors claim that the prior operator was “bad” and mismanaged the property. This might be true, but most mismanagement relates to missed revenue opportunities versus missed expense opportunities.
There are significant differences between value added investing and stabilized investing. For this assignment, determine top five differences that should be noted when investing.