The Truth About “Value-Add” Real Estate Deals

If you’ve spent any time looking at commercial real estate deals that are broadly marketed for sale, you’ve probably noticed that brokers are very quick to use the term “value-add” in their marketing materials (and for good reason).

The term “value-add” itself infers that there’s upside opportunity for the buyer in both operating income and future sale value, which can often push pricing significantly above what the property would have traded hands for without that upside.

But after underwriting thousands of these deals myself throughout my career, I’ve seen very clearly that just because a deal is marketed as having “value-add” potential doesn’t necessarily make it a good investment. And in this post, we’ll walk through four things that investors need to consider when analyzing value-add opportunities, and why these aren’t always everything they’re cracked up to be.

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Construction Risk Is Real

Investors looking for value-add returns are, by default, expecting higher returns than core or core-plus investors. But to generate those higher returns, they also usually need to make physical changes to the property itself through capital improvements.

And even though capital improvements can make a property nicer or run more efficiently, these also tend to come with significant economic risks, and cost overruns and major construction delays are very common occurrences in commercial real estate.

Even if construction projects do come in on time and under budget, there’s typically no guarantee that tenants will be able (or willing) to pay more than what they’re currently paying to rent space at the property, regardless of how nice those renovations are. And if capital improvements wrap up at a time when new supply in the market is high and rents and occupancy levels in the market are low, this can cause huge misses in projected returns to investors.

Even though a value-add deal requiring a major renovation might look good on paper, investors need to make sure they feel very confident in both the costs and the timeframe required to implement their business plan, and what the strength of the leasing market will be at the time those renovations are complete.

Not All “Value-Add” Deals Actually Have Value to Add

A buyer who believes they can increase the NOI and the value of a property will almost always be willing to pay more than another buyer who doesn’t see that same upside, and this often leads brokers to use this term when marketing deals that don’t actually fit into this category.

If a property was built in the last 5 years, if the seller renovated most (or all) of the property already, or if the demographics of the area just can’t support higher rents, these are all cases where the term “value-add” usually wouldn’t apply.

A great example of this would be a multifamily property that was built in the last 10 years in a low-income area in the outskirts of a major market, where the majority of the tenants are “renters by necessity.”

While brokers might say there’s an opportunity to push rents due to economic growth in a nearby metro or a lack of new supply being delivered in the submarket, if the median annual income in the area is $50,000 and you’d need to take rents at the property from $1,500/month to $1,800/month to hit your target returns, it probably isn’t realistic to raise rents to that level.

A renter that’s already maxed out and spending 36% of their pre-tax income on rent generally isn’t going to be willing to bump that up to 43% for the privilege of having stainless steel appliances or cooking on quartz countertops, so even if a renovation would make the property significantly nicer, the demand just wouldn’t be there at that new price point.

The key takeaway here is to always do your own research to make sure the value creation opportunity you’re being presented with is actually feasible, and to make sure your assumptions related to that value creation are all backed up by data.

Aggressive Financing Can Backfire

When deals are profitable and cash flow is strong, debt can be a great way for investors to add fuel to the fire. However, if things don’t go as planned and cash flow is tight, debt can significantly increase default risk.

Value-add deals are often financed with loans that include a short-term interest-only period, where the borrower is able to free up cash flow for the first 2-3 years of the loan term by only paying the interest portion of each loan payment.

But with value-add deals, by definition, you’re banking on being able to increase rents and the income a property generates. And if an interest-only period burns off before you can make those things happen, this can lead to major reductions in investor distributions, or even capital calls.

Many value-add business plans are also reliant on short-term hold periods, where the property is quickly sold within a 3-4 year timeframe. And because fixed-rate debt often comes with hefty prepayment penalties, floating-rate debt is also commonly used.

This can create serious issues for borrowers when interest rates rise unexpectedly, and this can also lead to higher cap rates in the market, which can make it harder to refinance or ultimately sell.

This is a big reason why many value-add investors will look at both levered and unlevered returns on a deal, to evaluate performance both with and without debt. While aggressive financing structures can make a deal look great on paper, cranking up your LTV just for the sake of improving return projections isn’t the smartest move when it comes to managing risk.

Market Factor Can Be Out of Your Control

Value-add business plans generally take anywhere from about 1-3 years to implement, which means that while an investor is renovating or re-leasing a property, they’re almost always going to be subject to changes in market conditions.

This means that even if the leasing market is strong at the time a property is acquired, if renovations won’t be finished for another 3 years after that acquisition date and a huge influx of new supply enters the market at that time, the rent premiums you may have underwritten as a result of those renovations might not end up materializing.

Changes to interest rates, consumer spending, income demographics, and even capital markets activity can all have a huge impact on rents and values in a market over time. And even though there’s a lot an investor can do to renovate a property and improve operations, the time it takes to make these things happen almost always comes with added risk.

How To Learn More About Real Estate Investment Analysis

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