Choosing the right rental property to invest in can be amazingly difficult at times unless you know the right question to ask.
The most successful real estate investors don’t focus on asking price, potential appreciation, or how much money they might make. Instead, they begin the search for their next acquisition by asking a very basic question:
“Does the amount of risk and potential reward of this opportunity match my investment strategy?”
Many investors today are discovering that value add real estate offers the best balance between risk and reward – or in other words, the biggest bang for the buck. In this article, we’ll look at some of the opportunities, risks, and rewards of investing in value add real estate.
There’s an Investment Strategy for Everyone
Investment strategies lie along different points of the risk-and-reward spectrum. A good illustration of this concept is the bond market, where different types of bonds can be purchased to match specific investment goals.
For example, US Treasury bonds (T-bonds) are backed by the full faith and credit of the US government. There is virtually no investment risk, but also very little reward. In exchange for the safety and security of T-bonds, investors receive an interest rate of less than 1%.
High yield bonds (sometimes called ‘junk bonds’) are on the opposite end of the risk-and-reward spectrum. Many of these high-risk bonds promise returns of 10% or more, according to a report by U.S. News & World Report.
Of course, there’s a reason the potential returns are so high, relative to a T-bond. High yield bonds also carry a very high risk of not paying interest or returning the principal due when the bonds mature, assuming they ever do. So, in exchange for receiving an interest rate that’s 10 times greater than a T-bond, investors accept a greater level of risk.
Three Main Real Estate Investing Strategies
Real estate investment strategies work in a similar manner. Although, it’s interesting to note that even what many investors consider to be the safest form of rental property investment offer returns three or four times higher than a Treasury bond.
Let’s look at the three main real estate investing strategies – core, opportunistic, and value add - and where they are located along the spectrum of risk and reward:
The core real estate investment strategy is similar to investing in US Treasuries.
Class A properties that are nearly brand new – or fully updated – in five-star neighborhoods with the best amenities and highest quality of tenants offer real estate investors a minimal level of risk. Vacancies are lower and rents are higher, but so are the prices of Class A real estate.
Because core properties are perceived to have a lower level of risk, prices per square foot are higher, generating a lower cap rate in exchange for the lower risk of problems with tenants and the property.
The opportunistic real estate investment strategy is similar to investing in high yield bonds.
Real estate wholesalers and investors who buy property to fix-and-flip practice an opportunistic investment strategy. They invest a lot of time, effort, and money to buy low and hopefully sell high for a quick profit.
If real estate markets were 100% predictable, then being opportunistic would make good business sense. However, in the real world, real estate markets move up and down, forcing high-risk investors to try and time the market.
In fact, different markets and even neighborhoods located right next to each other can perform differently. This makes it very difficult for an opportunistic real estate investor to make money over the long term.
That’s also why the value add investment strategy is so popular.
3. Value Add
Value add real estate sits right in the middle of the sweet spot between risk and reward.
The value add investment strategy is the perfect option for rental property investors buying Class B and Class C single-family houses and smaller multi-family dwellings. When the right value add property is purchased in the right market, higher returns are realistic with a manageable level of risk.
Investing in value add property can generate potential profits in two different ways:
- Yields and total returns may be increased by creating additional revenue streams or increasing existing income
- Market values are maximized by investing in rental property that promises the highest level of return in proportion to the total amount of capital invested (including acquisition and upgrade costs)
How The Value Add Investment Strategy Works
GlobeSt.com recently reported that the demand for single-family rentals continues to jump. According to the article, the demand for single-family portfolios with five or more homes has increased by nearly 650%.
A huge demand like this is music to the ears of the rental property investor, but there’s just one problem: There are only so many good single-family homes available on the market.
Of course, the best investors are the ones who can turn a problem into an opportunity. That’s one of the reasons the value add investment strategy is so attractive today. Some investors build portfolios of rental property to hold for the long term, while others rebalance an existing portfolio by packaging together a few homes and reselling them as turnkey rental property to another investor.
The nice thing about investing in value add real estate is that it comes in all shapes and sizes with different levels of opportunity. Here are some of the most common ways to make the value add investment strategy work in your favor:
1. Increasing rents with strategic improvements
Exterior and interior painting between tenants, updating the flooring and fixtures, and installing energy-efficient appliances can offer eco-friendly amenities to millennial renters who are willing to pay more for a nicer place that saves them money.
2. Creating additional income streams
Tenants are willing to pay a little bit more for things that make their lives easier. Extra storage space covered or off-street parking, fiber-optic internet, and weekly landscaping service are just a few of the items that most renters are willing to pay a little extra for.
3. Analyzing existing revenues and expenses
Profit and loss and pro forma income statements oftentimes lump revenues and expenses into only two or three categories, making it difficult to unlock hidden opportunities for adding value.
By digging deep and reviewing profit-and-loss statements by individual line item you may be able to find expenses that can be reduced to increase NOI (net operating income), or creative ways to generate extra income by passing through an expense to the tenant.
4. Managing your local real estate team
In order to maximize the profit potential of value add real estate, it’s critical to have a trusted local real estate team for each market you’re investing in.
Even in today’s internet-connected world, trying to manage real estate long distance is nearly a guaranteed way to lose money. Delegating to a team you know and can trust is a much more cost-effective way to increase income while you analyze the results and decide where to invest next.
Example of Value Add in Action
Many real estate investors are pleasantly surprised to learn that for every $1 increase in monthly NOI, the market value of a rental property could increase by $200 or more.
Let’s use the cap rate formula to see value add in action, in a market where cap rates for single-family rental property are 6%:
- Cap rate = NOI / Market value
- NOI / Cap rate = Market value
- $1 increase in monthly NOI / 6% cap rate = $16.67 x 12 months = $200 increase in market value
But it can get even better than that.
Raising NOI by $10 per month (or $120 per year) could increase the market value of a property by $2,000:
- NOI / Cap rate = Market value
- $120 increase in NOI / 6% cap rate = $2,000 increase in market value
While boosting the net operating income by $100 per month (or $1,200 per year) could create a gain in market value of $20,000:
- NOI / Cap rate = Market value
- $1,200 increase in NOI / 6% cap rate = $20,000 increase in market value
Keep in mind these potential gains generated by adding value are before the equity-building effect of long-term property appreciation is factored in.
Granted, there are probably better things you can think of doing than combing through a profit and loss statement to save a few dollars here and there. But, when you consider the magnifying effect that a small amount of additional net operating income can have on value add real estate, it can be well worth the extra effort.
Making the Most from Value Add Real Estate
Investing in value add real estate does take a little more time and effort, at least until you develop a system and have a local real estate team in place that understands how to help you achieve your investment goals.
As a value add real estate investor you need to know which markets are best and how to identify and profit from a property’s untapped potential. Once you’ve located a rental property with a strong value add opportunity, you and your real estate team need to have the know-how and discipline to carry out a program that increases yield.
When executed correctly, investing in value add real estate can incrementally increase NOI and cash flow during your holding period while generating a higher sale price when the time comes to sell.