Why Do Value-Add, Multifamily Properties Perform So Well?
Value-add real estate properties often outperform many other similar real estate investments. This type of real estate investing involves buying a property that has some form of deferred maintenance or physical deterioration, fixing it up, and selling it for a profit. The property may also suffer from improper management or below-average tenancy rates for the area, another couple areas where new ownership can potentially step in and add value without actually having to physically alter the property.
It’s riskier than typical “core” and “core plus” real estate investing because the property typically requires more capital investment to improve it which tends to utilize more leverage. However, the returns are, on average, much higher.
But what exactly makes a value-add property a good -- even great -- real estate investment? How do you know the increased risk is worth it and how do you know which properties to choose?
An Example of How Value-Add Works
Value-add has one of the highest expected returns, somewhere in the realm of 12-17%. This is because the risk and return profiles for each type of investing are so different. Put simply, value-add investing has higher expected returns because it requires more work, investment, and execution capability to achieve a higher return. While the work required presents higher execution risk, the reward payoff is earned when executed well. This is in contrast to investing strictly in stable, mature buildings in densely populated metropolitan centers, the type of investment popular in core and core plus.
In real estate, there are two terms to differentiate physical deterioration on a property: “curable” and “incurable.” If it costs $50,000 to replace the HVAC system inside of a large building and an economic analysis reveals that a new HVAC system would increase that property’s value by $75,000, the repair is not only economically feasible (and therefore “curable”), it’s desirable. There’s a potential gain of $25,000. That’s not to mention the probable appreciation that could occur over time due to growing market demand.
However, whether it’s due to poor money management, a bad managerial structure, or plain old bad luck, the owners of that property may not be able to afford to replace the HVAC system.
Expert real estate investors, like those of us here at Valiance Capital, actively seek out these types of opportunities. There are unrealized gains to be made in key markets, and we identify those properties that are lacking proper amenities, facilities, and management in attractive markets and completely re-engineer those properties.
How Do You Know if a Value-Add Investment is Good?
What does value-add investing mean for you, the average real estate investor? How do you benefit from something like that? And how can you tell if it’s something you really want to go in on?
As with any investment, there are inherent risks involved. You can never be 100% sure that any single project is going to be successful, but there are some specific factors that play into the success of value-add projects.
Analyze the Market and Property Type
One of the key factors that determine whether a value-add investment will succeed is the market and property type itself. If the particular property type is in demand and the market is poised for growth, consumers in that area will drive prices higher and higher. That’s basic supply and demand.
For example, at Valiance Capital, we focus on multifamily and student housing in California and Texas. In California, student housing is in such high demand that UC Davis reported only a 1% vacancy rate due to the pandemic, which is double that of 2018 when it was a mere 0.5%. More broadly, student homelessness across the entire state has increased by 50% in the last decade. There’s clearly incredibly high demand for housing, a demand that we’re positioned to fulfill.
If you believe in the market fundamentals of the investment, you’re one step closer to determining a value-add property that’s likely to be very successful.
The next step, though, is to analyze the firm itself.
Make Sure the Firm is Reputable with a History of Solid Returns
After you’ve determined that the market and property type are in line with your particular portfolio and broader economic predictions, do some digging on the returns of the private equity real estate group itself.
This process is as simple as asking the prospective investors about their annual returns and their expected returns for an investment that they’re making soon. Seek examples of past investments and the performance of them. Look for proven track records. If they’re experienced, they’ll be happy to provide investors with any information that they want to know.
Questioning the firm is especially important if they’ll be responsible for restructuring the management of the property. As mentioned above, many properties need intangible and tangible work. It’s important to evaluate the company on their ability to improve those intangible assets, so that they’re prepared to deal with management and operational issues.
Check if the Investment Fits into Your Portfolio and Timeline
For good reason, different investments draw different crowds. Income-producing, stable core investing is enticing to older investors not because the potential returns are high but because the potential risks are low (or at least lower than many other forms of real estate investing).
However, if you’re a younger investor or an investor who can weather potential volatility, value-add property investing has the potential to be a fantastic addition to your portfolio.
Additionally, read more about one of the key benefits to real estate investing: the tax benefits. From the 1031 exchange to depreciation write-offs, value-add investing maximizes all of the potential tax benefits.
The Tax Benefits of Value-Add Property Investing
The benefits of real estate investing certainly aren’t limited to the returns themselves, and so expected ROI only tells part of the story.
For one, value-add property investing is usually subject to the 1031 exchange. This tax strategy allows real estate investors to defer paying capital gains tax on real estate as long as they use the funds from their previous real estate investment to fund the next.
For average investors looking to move out of managing single-family rentals and into something that’s a bit more passive, for example, this is a fantastic option for funding their stake in the new venture.
Furthermore, depending on whether you have real estate professional status, you’ll be able to use the depreciation from value-add investments to offset your total income. If you don’t have real estate professional status, you can still use that depreciation to offset passive income gains.
At Valiance Capital, we understand that it’s not just about how much money you make, it’s about how much money you keep. From installing solar panels to maximize rebates to utilizing favorable fixed-rate loans under HUD 223(f) to our accelerated depreciation strategy, we maximize every available option to optimize realized income and tax benefits for our investors.
The full list of potential tax benefits for real estate investors deserves an article in itself, so we’re only addressing the tip of the iceberg here.
Conclusion: What Makes a Value-Add Property a Great Real Estate Investment?
Value-add property investing is a great option for investors who are willing to take on a bit more risk with the potential for high returns.
When you fix up a property that’s in need of repair, you can generate higher revenue by charging higher rents, benefit from virtually every tax benefit available to real estate investors (including depreciation write-offs and the 1031 exchange), and, ultimately, add value to the building itself, allowing you to sell it for a higher price.
Investors can narrow down their search for good value-add opportunities by looking at in-demand property types in growing markets (or markets that they expect to grow). As the saying goes, “a rising tide lifts all boats.” When the market is experiencing growth in general, virtually every business and investment will benefit. Additionally, consider the background and returns of the equity group itself and don’t hesitate to ask for annual returns. Finally, consider how the investment fits in with your overall portfolio.
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Valiance Capital is a private real estate development and investment firm specializing in student and multifamily housing.
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Berkeley, CA 94704
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©2023 Valiance Capital. All Rights Reserved.
Investing involves risk, including loss of principal. Past performance does not guarantee or indicate future results. Any historical returns, expected returns, or probability projections may not reflect actual future performance. While the data we use from third parties is believed to be reliable, we cannot ensure the accuracy or completeness of data provided by investors or other third parties. Neither Valiance Capital nor any of its affiliates provide tax advice and do not represent in any manner that the outcomes described herein will result in any particular tax consequence. Offers to sell, or solicitations of offers to buy, any security can only be made through official offering documents that contain important information about investment objectives, risks, fees and expenses. Prospective investors should consult with a tax or legal adviser before making any investment decision. For our current Regulation A offering(s), no sale may be made to you in this offering if the aggregate purchase price you pay is more than 10% of the greater of your annual income or net worth (excluding your primary residence, as described in Rule 501(a)(5)(i) of Regulation D). Different rules apply to accredited investors and non-natural persons. Before making any representation that your investment does not exceed applicable thresholds, we encourage you to review Rule 251(d)(2)(i)(C) of Regulation A. For general information on investing, we encourage you to refer to www.investor.gov.