What is Value Add Real Estate Investing and How You Can Make It Work For You
We know that Commercial Real Estate Investments have some of the best advantages for returns when compared with Residential Real Estate. What strategies allow us to achieve great returns for our investors?
When it comes to Commercial Multifamily real estate investing, there are three main strategies:
#1 – Core Investments
The Core Strategy is for those looking for a conservative return with minimal risk. Regarding multifamily properties, a core real estate example would be Class A properties. These are newer properties in upscale neighborhoods with high quality luxury amenities. Typically, core properties have higher rents with a lower vacancy rate.
This in turn helps to mitigate risk generating a lower cap rate in exchange for the decreased amount of problems with the property.
#2 – Opportunistic
Unlike the core real estate strategy, using opportunistic strategies are the riskiest of all. These investors are looking for the potential highest returns in “opportunity” which is usually property that is bought low with the hopes of selling high for a quick profit.
These projects often initially have minimal to no cash flow with a larger potential later once the property has been rehabbed.
An example of this type of investment in the multifamily space would be new construction of an apartment building. Usually large amounts of capital are needed due to high construction costs which in turn will hopefully attract tenants that can pay an above average rent.
The key to success in this area is using a highly successful team with experience in:
- land development
- repositioning buildings from one use to another
- ground up developments
#3 – Value-Add Real Estate
Most of the syndication deals we’re invested in reside in the value add class which consist of Class B and Class C property.
Most are familiar with fix and flips as this would be a type of value add in the single-family home space. This is where someone finds and purchases a home that needs some TLC, rehabs it then sells to a new owner for a profit.
So this person is rewarded for taking on a high risk hoping to improve a home to the point where it’s sold to someone at a cost that will at least cover the home’s price and rehab cost.
The value-add component is similar to the fix and flip model when it comes to the multifamily space except on a much larger scale.
Instead of renovating one unit, we’re talking about multiple units depending on how large the apartment complex is.
What Are the Risks In Value Add?
As you can imagine, when purchasing a property that needs improving, its condition could be lacking in several areas.
Depending on how run-down the property is, the amount of construction could be quite high which would significantly add to the risk of the project. Usually the more involved renovations (major overhauls) needed, the higher the risk.
Other risks can involve the tenants.
Typically rents can be increased after the rehab has been completed. Occasionally this can cause some to move out and also make it difficult acquiring new tenants which contributes to the overall risk of the project.
Value-Add Examples – Physical Improvements
Value-add real estate is typically a B or C class property that has outdated appliances, peeling paint, distressed landscaping and more. Many times updates need to be made to both the exterior and interior of the buildings.
Here’s a few capital improvements that can be performed.
Interior updates
Common value add interior updates include:
- upgraded fixtures
- new flooring/carpet
- granite countertops
- stainless steel appliances
- new cabinets
- painting units
- new lighting
Exterior updates
Adding value to the exterior of the buildings along with some of the shared spaces include:
- new signage
- update fitness center
- new pool or rehab existing one
- parking lot
- painting
- update clubhouse
- new landscaping
- covered parking
- playground update
- shared spaces (BBQ pit, picnic area, etc.)
3 Reasons Value-Add Investing Can Work For You
#1 Rent bumps
One of the major reasons why a value add play can work has to do with increasing rents.
Many times the property has below average rents which sets it up nicely for the sponsors to justify the increase. Once they make interior and exterior improvements, the net operating income (NOI) will increase which can greatly increase the building’s value (an example of this is below).
#2 Additional income streams
We all love extra conveniences, right? Your tenants will too when it comes to making their lives easier. And they’ll also be willing to pay more for these such as:
- covered parking
- high-speed internet
- cable/satellite
- Amazon package lock boxes
- washer/dryer
#3 Analysis of existing operations
On occasion, the property’s different revenue streams and expenses can be placed in incorrect categories on the profit and loss statement making it tough to find opportunities for value add (poor management).
A good sponsor team will be able to find creative ways to create extra income if some of the expenses found can be passed along to tenants.
Also, the Net Operating Income (NOI) can be increased if some of these expenses can be somehow reduced.
Conclusion
The bottom line is that every commercial real estate strategy has both risks and benefits. Higher risks have the potential to produce higher than average returns, but when making the decision to invest passively, be sure you know the team’s track record and experience with that specific strategy.
What This Means For You
We have created a system for you to invest directly into cash-flowing, hard assets that don’t require you to manage tenants or deal with any of the headaches that come from owning Single Family Homes. This gives you the freedom to use your time as you wish while we grow your wealth through these amazing assets!
If you are looking to secure your financial future, we would love to connect with you and explore partnership opportunities!
To Learn More about the many benefits of investing in Multifamily Apartments, Download our Free Passive Investor Guide today!
You can set up a complimentary discovery call to join our investor network with one of our team members here!
What is the Capital Stack?
A Commercial Real Estate Investment’s ‘Capital Stack’ is arguably one of the most important concepts an investor needs to analyze the equity, debt, and risk return profile of a project. Ultimately, as with any investment, commercial real estate comes with some downside risk. Investors who understand the Capital Stack can assess risk and repayment, where they fall in the pecking order of cash flow, and whether or not that investment is worth the assumed risk.
Let’s Dive In!
The Capital Stack is the structure of all capital that is invested into a company. At a high level, this means that the capital stack includes both equity and debt invested. More specifically, though, this means all types of both equity and debt.
- Tiers of financing sources – such as equity and debt
- Order in which investors are paid back through income and profit distributions over the entire holding period.
- Repayment rights in the event of a default
Layers of the Capital Stack
- Capital Stacks prioritize different capital types by seniority, with the least senior on the top and the most senior on the bottom. Equity positions are registered first, with debt positions below.
- When it comes to properties that are unable to generate enough cash to pay all investors or lenders, capital listed on the bottom of the stack will be paid first and any leftover cash then flows to the capital that holds the next lowest position.
- Should issues arise and the property goes into default, claims to assets are processed in order of seniority in the capital stack with the lower placed capital retaining foreclosure rights superior to those higher up in the stack.
- In most cases, higher risk capital sits at the top of the stack, while lower-risk sit below, and the lowest at the bottom. In a similar vein, higher return potential typically sits at the top of the capital stack, with expected returns that decrease as you go down the stack.
Here is a run-down of primary sources of Capital most commonly seen in the ‘Capital Stack’:
Common Equity
Common equity sits on top of the capital stack and offers the highest potential reward in exchange for the highest level of risk. People who invest in the common equity of a project own a piece of the property and receive a share of the recurring cash flow and percentage of profits when the property is sold. However, funds are distributed to common equity investors only after the debt has been serviced and the investors at the lower levels of the capital stack have been paid.
Preferred Equity
Similar to the way that a first position mortgage has priority over a second position mortgage, preferred equity holders have priority over holders of common equity. Investors with preferred equity have the first right to receive a pro rata share of the monthly cash flow, along with a percentage of the profits when the property is sold, before the common equity holders are paid. Although preferred equity has priority to common equity, the rights of a preferred equity investor are lower than those of the debt holders.
Mezzanine Debt
Mezzanine debt is similar to a second position lender, and is usually unsecured by the real property. The rights of mezzanine debt holders are subordinate to senior debt holders, but hold priority over preferred equity and common equity investors. Because holders of mezzanine debt are not paid until payment has been made to senior debt holders, the interest rate paid to mezzanine debt holders is usually higher than senior debt. Sometimes mezzanine debt holders will also receive a small percentage of the profits when the property is sold, or an interest rate ‘kicker’ if the project performs better than expected.
Senior Debt
Senior debt sits at the bottom of the capital stack and serves as the foundation for financing a real estate investment. Because the real property typically serves as collateral for senior debt holders, investing in senior debt comes with the lowest level of risk. Holders of senior debt receive periodic interest payments before all other investors higher up in the capital stack are paid, and are first in line to have any outstanding debt repaid when the property is sold. Interest rates paid on senior debt are usually lower than rates paid on mezzanine debt, and may be viewed as having bond-like characteristics for investors seeking a truly passive income stream.
We at The Joint Chiefs of Real Estate have created a system for you to invest directly into cash-flowing, hard assets that don’t require you to manage tenants or deal with any of the headaches that come from owning Single Family Homes. This gives you the freedom to use your time as you wish while we grow your wealth through these amazing assets!
If you are looking to secure your financial future, we would love to connect with you and explore partnership opportunities!
To Learn More about the many benefits of investing in Multifamily Apartments, Download our Free Passive Investor Guide today!
You can set up a complimentary discovery call with one of our team members here!
Should you pay off your mortgage?
For most, paying off your mortgage is a personal decision that factors in comfort level of how much debt you have. For me, instead of paying off my mortgages, I leverage that debt to invest in more real estate. First, let me explain leverage.
What Is Leverage In Real Estate?
Greek philosopher Archimedes once said: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.”
If you’re a home owner, then you’re well aware of what it means to use leverage in real estate. Leverage allowed you to borrow money to help finance your home in the form of a mortgage. Most millionaires and billionaires have real estate in their portfolio. Why? They know that a major advantage is something called financial leverage.
Leverage in real estate means buying property with debt instead of paying cash. This allows you to buy a much larger asset and increase the potential return on your investment than you could if you had to pay 100% of the purchase price upfront.
Now that we understand Leverage, should you pay your Mortgage off.
I say No and here’s why. Before I knew about Real Estate, my original investment strategy was to invest in index funds as it was all I knew about saving for retirement. If I put $100,000 into an index fund, then I could only purchase that amount as a shareholder. On the other hand, I could use that same $100,000 and leverage it to buy an investment property that was a much higher valued asset.
With interest rates at historical lows, there is an opportunity to use cheap debt as leverage to increase your real estate portfolio. If you currently have a property that has equity in it, you should consider pulling that equity out with a refinance and taking advantage of the low interest rates. Instead of paying off your mortgage you can apply that equity and take advantage of financial leverage. Just like I mentioned above that most millionaires and billionaires do.
Let’s take a look at how I recently used leverage as an active investor after taking equity from one of my SFH rental properties. Before refinancing this property, I was making about $350 a month in cash flow but had a high interest rate with a lot of trapped equity. After the refinance, I pulled out about $100K of equity, dropped my interest rate substantially but did reduce my monthly cash flow from $350 to $275.
You might be saying well that doesn’t make sense because you reduced your cash flow by $75 a month and took on more debt since you have to finance that additional 100K pulled out. ($75* 12 months = $900 a year in reduced cash flow). Well, let me show you how I leverage that $100K instead of paying the mortgage off of the SFH rental.
With my partners, we purchased an apartment building as a joint venture and my investment of $100K was used as a portion of the down payment to finance this asset. After all expenses and mortgage, we projected this investment will produce 13% to 15% annual (CoC) cash on cash return. To be conservative, let’s say it’s a bad year and I only make 10% return on my investment. With only 10% return that means I made $10,000 return for the year and even after considering the monthly income lost of $900 from the refinanced property, I still cleared $9100. Let’s do the math.
10,000 (CoC on $100K investment at 10% return)
-900 (reduced cash flow on refinanced SFR)
$9100 (total return after accounting for reduce cash flow from refinanced SFH rental)
This is a very simplistic way to look at this but not only did this new investment make up for the lost cash flow in the refinance, but it greatly increased my monthly returns. What else to remember is I now own 25% of a multimillion-dollar apartment building that over time will appreciate as the mortgage is also paid down by the tenants. This scenario could easily be replaced with a SFH rental investment.
And that is the magic of using leverage in real estate.
Be cautious with debt.
First off, real estate investing should be viewed NOT as a liability but as an asset that is sustainable in paying all operating cost and debt while providing cash flow. Before taking on additional debt, you need to stress test the real estate investment to understand when it goes from being an asset to a liability. For example, in this multifamily investment if it went under 60% occupied it was longer considered an asset and instead was losing money – becoming a liability. In SFH Rentals, maybe over three months vacancy is when this creates a hardship and becomes a liability. Each investment is different.
By stress testing your investment, you can better understand the right amount of debt that is manageable and what reserves are required in an underperforming rentals. Underperforming rental properties may be manageable for the near term with being over leveraged but you also need to consider a downturn in the market. You need to ask yourself what if there is a major downturn in the market and this property is making no income. Worse what if this occurs across several of your properties and you are now having to pay several large mortgages out of your own pocket.
Summary
For me, I’d rather carry debt on my real estate investing and leverage that debt to grow my portfolio. Debt is cheap right now and I highly recommend that you use the equity instead of paying off the mortgage. Just don’t get carried away in over leveraging yourself.
If you have any additional questions, please email me directly at James@jcoreinvestments.com