Real estate value-add strategy - Part 1

 

I remember when I first started in real estate, people talk about value-add deals all the time. It all sounds really cool but I was clueless. Well, not exactly, I know you can buy fixer-upper, renovate it and flip for profit. But I wasn’t sure how it works in the apartment business.

I spent a couple of months going through value-add deals on TheRealDeal (going back two to three years). The analysis got easier once I passed the 50th deal and when I hit the 100th deal, I think I figured it out! By the way, that’s another topic I can hardly find any good articles on the web. Maybe it’s too simple, no one bothers to write it up. Here is what I came up with and hope it can help someone having the same question like I did.

In a nutshell, you find a building with units that can be renovated to achieve higher rents and/or enlarged using available air rights to generate additional income. Once renovation or enlargement completes and units are leased up, you will refinance the building with a “take-out” mortgage which hopefully covers the project loan (acquisition and construction) and also returns a sizable portion of the equity investment if not all.

Table below is a representation of the unit economics for the strategy. As you can see, value-add strategy can achieve very impressive returns for the equity investors.

	Acqui- sition	Value-add	Over- all
Income (PSF)
Current rents	$50
30% Rent increase		$15
Proposed rents			$65
NOI (70% of rents)	$35	$11	$46
Cost (PSF)
Purchase (4% cap rate)	$875
Construction ($100 PSF)		$100
Total cost			$975
Capital (PSF)
Equity (40% cost)	$350	$40	$390
Project loan (60% cost)	$525	$60	$585
Take-out mortgage (PSF)
Valuation (4% cap)	$875	$263	$1,138
Gross proceeds (70% LTV)	$613	$184	$796
Net proceeds (gross - debt)	$88	$124	$211
Distribution (net proceeds/equity)	25%	310%	54%
Return (PSF)
Yield (NOI/cost)	4%	11%	5%
ROI (NOI/equity)	10%	28%	12%

All numbers are based on price per square foot. For simplicity reasons, the calculation does not take time into consideration and IRR is not included. All numbers are before taxes, therefore annual tax benefits from depreciation and mortgage interest are not considered. Preferred returns on equity investment is not considered as well. Finally reversion is not included in the calculation, which will increase the overall returns meaningfully.

The table also reveals the classic concept on the relationship between risk and reward, as discussed in my other post Public Market or Private Deals. Column Acquisition represents a typical “core” investment strategy with very limited risks and therefore its return is also limited. Column Value-add represents a strategy seeking high growth with more risks involved and therefore its return is significantly higher than “core” strategy.

	Acquisition as “core” strategy	Value-add strategy
Capital required	High	Low
Risk Profile	Low	High
Yield	4%	11%
ROI	10%	28%
Distribution from take-out mortgage	25%	310%

Above is a summary table highlighting the differences on the returns between the two columns. It shall be noted that “Value-add” required very limited capital and achieved much higher returns compared to Acquisition as “core” which needs a lot more capital but delivered very modest return. Fundamentally, the capital market is a market that trades risk. As investors seek opportunities with higher returns, the associated risk increases as well.