Introduction
Perhaps the most well-known value-add strategy is the “fix-n-flip” or the “BRRRR.” Executing a value-add real estate strategy takes additional time, risk, and expertise than more passive approaches. As risk and effort increase, however, so do potential returns. Thus, it is important to understand the impacts a value-add strategy may have on your risks and return as an investor.
The most common value-add strategies are improving a dilapidated property (fix-n-flip and BRRRR), financial or management restructuring, development, and re-development.
- WOB in the MOB
One of the primary advantages of renovation projects is the potential for significant financial gains. This often applies whether you plan to resell it (fix-n-flip), or are executing the buy, remodel, rent, refinance, repeat model (BRRRR). Dilapidated properties are often priced lower than their market value. When I buy these projects, I look to purchase properties for 80% of what the value of the property will be after repairs, or the “ARV,” minus what the cost of the repairs and interest during the remodel period.
In my career targeting run-down properties, I look for the WOB in the MOB. That is, the property that is the worst on the block of a middle-income area. Because the final product will be affordable to most people in the market, there will be a high demand and it is a lot easier to determine what the sales price or rents will be.
However, remodels require acknowledgement, and mitigation of, the associated risks. Renovating a dilapidated property can entail unforeseen challenges, ranging from unexpected structural issues to escalating renovation costs. It is nearly impossible to determine every repair that will be required once you punch a hole in the wall. Additionally, construction costs and timelines can increase, which also increases your interest cost. We saw this during the COVID pandemic when market forces simply put unprecedented pressure on the cost of construction. Occasionally, delays with local zoning regulation and obtaining permits can be time consuming and expensive.
Don’t get caught up in optimism. Make sure that you have great comparable properties or appraisals to verify your projected ARV, a realistic budget, and a contingency plan to mitigate unexpected obstacles that may arise during the renovation journey.
- Financial or Management Restructuring
Acquiring and restructuring the management or finances of real property is one of the best value-add strategies for commercial properties, such as an apartment building, self-storage facility, or office building.
Financial restructuring is likely the best opportunity in real estate in the current market environment. Much like the commonly-used ARM loans leading into the 2008 crisis, commercial loans nearly always include a balloon payment every 2-10 years. Years of abnormally low interest rates pushed commercial values very high. However, hundreds of billions of dollars of commercial loans are coming due every year. Due to the increased interest rates, many owners may be unable to make payments on refinanced loans and will be required to come up with large cash buy-downs to refinance their properties. With this financial stress comes opportunities. Renegotiating loans or optimizing expense management can result in cost savings and increased cash flow. This approach allows property owners to maximize the return on their investment and make the real property a more attractive asset in the market. Moreover, a well-executed restructuring plan can position the property for long-term financial stability, making it an appealing prospect for potential investors or buyers.
For management restructuring, the key advantage lies in the potential for improved operational efficiency and increased property value. Restructuring management practices can lead to streamlined processes, better tenant relationships, and enhanced property maintenance, ultimately contributing to higher tenant satisfaction and retention.
Acquiring and restructuring the management or finances of real property is not without its challenges and risks, however. Mismanagement or a poorly executed restructuring plan can lead to tenant dissatisfaction, increased vacancies, and a decline in property value. Additionally, navigating the complex landscape of financial restructuring, such as refinancing or debt restructuring, requires a thorough understanding of market dynamics and financial regulations. Timing and a clear vision of what is reasonable is crucial because market conditions and interest rates can impact the success of these endeavors. Restructuring strategies provide great opportunities for experienced investors who can take advantage of these complex, fact-intensive scenarios.
- Development
Developing land carries great value-add opportunity. Purchasing farmland and creating revenue-producing real property can realize the difference in value between farmland and the future use, potentially including high-density. You will also realize the value of equity created by adding infrastructure and amenities to the property, as well as the value for building the project and leasing it up.
However, land eats three meals a day. Between 2008 and 2012, I bought a number of homes in the Midwest for $5,000 or less. Many of them were livable homes. Banks sold them so cheap because they had costs, and no revenue. That means that they were losing money every month. When you own land, you likely get no revenue. However, you are likely paying interest (or opportunity cost), taxes, and insurance. Make sure you have a clear plan to change that status.
Additionally, when you develop land, you must create a vision of the highest and best use of the property. That is, what use is physically possible, legally permissible, financially feasible, and maximally productive. There is a more sophisticated set of requirements to understand federal, state, and local laws and rules for the use of the land and approval of changes. You must also be sure that there is a market for what you are building. The axiom “if you build it, they will come” does not apply. When pursuing this strategy, ensure that you have experienced and specialized team members before you take any steps forward, either partners or contractors. This list may include engineers, surveyors, attorneys, accountants, building, developers, and more.
- Redevelopment
Redevelopment is similar to development, except the land is either all or partially built out. Redevelopment can be a hybrid between development and renovating existing property. First, I always look for the WOB in the MOB, just like for renovations. Second, I look for properties with unused land. Third, I try to find properties that are being used for something that costs less to rent or buy than the surrounding land. For example, find old, small houses surrounded by a mall.
Redevelopment carries many of the risks and upsides that development and renovations do. However, it may be easier to determine future potential rents or sales prices due to the comparable properties in the neighborhood. Additionally, depending on the plan, you may be able to continue to make some revenue on the existing uses while you add additional buildings.
However, the prices of these properties may be very high compared to regular developments. Further, you may also have neighbors who may resist your efforts with the local government. Once again, before you undertake a redevelopment project, be sure you have built a team of knowledgeable key players.
BONUS: NEVER DO REAL ESTATE IN SLOW MOTION
Never do real estate in slow-motion. Never do real estate in slow-motion. For the past many years as real estate values have been increasing in the double digits, slowing down due to a lack of preparation, financing, or unexpected delays, has been to the benefit of the investor. Interest costs rise, but values rise faster. However, in the current condition, interest rates are already much higher than in the past for repositioning an asset. Further, values are mostly stagnant or dropping. Therefore, any delay brings down your gross revenue and increases your already high interest cost. Be the quick, not the dead.