Is value-add real estate the right move for you? The quick response is “it depends.” There are several factors to consider, and if the answer turns out to be “yes,” there are a couple of important follow-up questions that essentially boil down to “How should you invest in value-add real estate?” For all the right answers to these questions look at this blog and find out more.
Kent Ritter is an experienced multifamily syndicator and operator helping you to build real wealth through real estate investments. Learn More
Why Invest in Value-Add Real Estate?
People invest in real estate for some compelling reasons: cash flow from net rental income (which increases over time as rents go up); tax advantages due to the deductibility of operating costs and depreciation; asset appreciation and a profit upon the sale; portfolio diversification; as a hedge against inflation; and to build wealth.
All real estate investments offer the same advantages, to one degree or another and with varying degrees of risk. Value Add real estate falls on a risk/reward continuum in between opportunistic (AKA distressed) real estate and core (AKA turnkey) real estate. Real estate investors typically adhere to one of these three investment style preferences.
As the name suggests, opportunistic real estate has a high upside potential, but it also carries higher risk. It’s referred to as distressed real estate because it typically requires a greater investment of time and money to remediate problems and make improvements that will attract tenants and command higher rents.
At the opposite end of the risk/reward continuum, core real estate offers a lower upside potential, but also involves less risk. These turnkey properties require little if any improvement to provide a reliable stream of rental income.
Value add real estate has high upside potential, like opportunistic real estate, but with lower risk, like core real estate. It offers the best of both worlds. It’s called value add real estate because realizing that higher upside potential requires making improvements that will add value to what is already a stable asset. It’s like taking a good property and making it great.
How Does Value Add Investing Differ from Flipping?
While there are some similarities, these are two distinctly different ways of making money from a real estate investment. Flippers typically buy an unoccupied property, often a single-family home, quickly make improvements to increase its value, and sell it at a profit.
Value-add investors usually buy occupied, undervalued, multi-unit rental properties (residential or commercial), make improvements, and enjoy the cash flow from rents for a period of years while the property appreciates before selling at a profit. The improvements can be physical upgrades, interior or exterior, new amenities, or on-site services, or they can be changes that improve building management and increase operational efficiency. They typically improve cash flow, either by justifying rent increases or by decreasing operating expenses.
Another major difference between these two approaches to investing in real estate is that flipping is easily done by an individual, especially by someone with some experience as a general contractor. Value add investing typically involves larger projects and more complex financing arrangements that could strain an individual’s resources and exceed their risk tolerance. But that doesn’t have to mean you can’t reap the benefits of investing in value-add properties.
What is Real Estate Syndication?
You don’t have to go it alone. One common pathway into value-add real estate investing starts investing in a real estate syndication deal. It’s the same approach as buying shares of a stock to gain ownership in a company.
A syndication is a temporary partnership specifically designed to make a large investment that would be beyond the reach of an individual. A syndication is typically made up of two groups: the general partners and the limited partners.
The general partners, or syndicators, select the property, create a business plan, put the deal together, arrange the financing, bring in limited partners, purchase the property, plan and execute the improvements, arrange professional property management, make cash flow distributions to the partners, and eventually sell the property and distribute the capital gains.
The limited partners, with limited liability, are essentially passive investors. They provide much of the capital the syndication needs to purchase a property and receive ownership shares in return for their investment. Through a value-add real estate syndication strategy, both general and limited partners benefit from regular cash flow, high returns, capital gains, and tax advantages.
How Do Syndicators Choose a Property?
Different syndicators have different investment philosophies and different criteria for choosing value-add properties to purchase. Some invest primarily in commercial properties while others choose multi-unit residential properties, and some invest in both, depending on the opportunities that present themselves. Residential properties have an edge over commercial ones in terms of cashflow because residential leases typically run for one year, providing an annual opportunity for a rent increase. Commercial leases are often multi-year, which means less frequent rent increases.
The number of units is another key consideration. The more units there are, the greater the monthly income from rents and the more stable that income is the loss of a tenant has less impact on total rental income. Properties with more rental units also provide economies of scale that result in a lower operating cost per unit.
Location also enters the selection process. Clearly, there is greater room for appreciation in areas where the demand for rental units equals or exceeds the current supply, particularly where income levels don’t support purchasing a single-family home. And property condition is a factor because the need for extensive renovation can limit the upside potential.
Syndicators have the experience and resources to perform the underwriting and due diligence to minimize risk while maximizing income during the holding period and the profit potential from the eventual sale of the property. Few individual investors could do the same on their own. If you’re interested in joining my (Kent Ritter) investor list you can do that here.
How Do Limited Partners Make Money?
Syndicators start distributing net income to limited partners within a year or less from the property acquisition date, usually on a monthly or quarterly basis. Net income, also called free cash flow, is what remains from gross rent receipts after mortgage payments and operating expenses have been subtracted. Each distribution is proportional to the size of a limited partner’s investment, which averages $100,000, though the minimum investment amount typically is $50,000.
Distribution details are spelled out in the Private Placement Memorandum (PPM), which outlines the terms of the syndication’s offering for potential investors. Limited partners can assess the cash return on their investment using the cash-on-cash (COC) return rate (cash flow received divided by their initial investment).
Limited partners also receive a proportional share of depreciation from improvements to the property as a tax deduction, which can help offset income from net income distributions. When the property is sold at the end of the holding period, limited partners receive a preferred return (a stated percentage of their initial investment) before the general partners, who also have skin in the game, receive their share of the sale proceeds. But you may not have to wait until the property is sold to get some of your investment returned to you. In many cases, the improvements made to the property will enable the general partners to raise rents within a couple of years and then refinance the property based on an increase in its value and the increased revenue from higher rents. This cash-out refinance strategy allows the general partners to pull out some of the equity in the property and distribute it to the limited partners, giving them back a portion of their initial investment without creating a taxable event.
What Qualifications Are There for Becoming a Limited Partner?
To invest in any real estate syndication, you must qualify as either an accredited investor or a sophisticated investor, depending on the terms of the offering. Certain syndications may only be offered to those who meet the criteria to be approved as an accredited investor—a minimum annual income of $200,000 (or joint income of $300,000 with a spouse) or a net worth exceeding $1 million. More often, real estate syndications may be offered to people who are considered sophisticated investors by virtue of having in-depth investment knowledge and experience.
Takeaways for Investors
Investing in value-add real estate offers higher return potential and lower risk than investing in core or opportunity real estate, but no real estate investment is risk-free. Value add investing is easiest and safest if done through a syndication with an outstanding reputation and solid track record.
Becoming a limited partner gives you a source of regular, passive income for a certain number of years, during which the syndication’s equity in the property increases and the property appreciates, while you enjoy some tax advantages. When the property is sold, you’ll receive a share of the sale proceeds.
These can be compelling reasons for investing in value-add real estate, provided it’s the right offering.
Kent Ritter is an experienced multifamily investor and entrepreneur empowering you to build real wealth through real estate syndication. Learn More.
