In the lexicon of real estate investing there are three primary types of investments. In order of risk from he lowest to the highest they are Core (typically fully leased and cash-flowing), Value-Added (the real estate version of Streetcar’s Blanche Dubois, something of a a faded rose) and Opportunistic (visionary, big-picture thinking, but the bank won’t return your phone calls). Today I will focus on the the valued-added investor.
Valued-added investors, as the name implies, try to identify properties with relatively curable problems and increase their value with modest improvements. Potential value-added acquisitions often have poor or unprofessional management, issues of physical depreciation, or are capital starved.
“Mom and Pop” properties often fall in this category. Que the back-in-time fade effect:
Years ago Mom and Pop had a thriving textile business specializing in ascots. They outgrew their rented third floor sweatshop space in Brooklyn and decided to buy a property in the promised land of New Jersey. The business grew and they added to the building several times. As “the talkies” became popular and ascots went out of fashion, they closed the business and rented the building to several tenants.
Fast forward to today. Pop passed away in 1992 and Mom went not long after in 1994. Today their three children own the property and the middle brother, who lives closest, is the property “manager”. By now the the property is badly in need of investment. The roof needs to be replaced and the asphalt parking lot is more gravel than anything else. The siblings decide to sell.
Enter the value-added investor, who is willing to buy at the right price, that is, value minus the cost of the required capital investment. The siblings wail and gnash their teeth at the offer, sure this asset was their ticket to easy street. The siblings (ever so slowly) face reality: if they don’t sell they will have to cough up cash, and they relent.
The value-added investor then begins to, well, add value. And here is what the market sees:
- Everything Works: The roof doesn’t leak. The heat heats and the air conditioning cools. Light bulbs are replaced. The bathrooms are clean and paper goods are always in good supply. The parking areas are paved and striped and the signage is clear and helpful to visitors.
- Cosmetics Count: The building is power-washed and painted. The landscaping is redone with new sod, shrubs, perennial flowers and irrigation. Common areas get new paint and carpet and maybe even some artwork from Costco. Awnings add some pizzazz.
- Active Management: Tenants are treated like valued customers. The valued-added investor gets to know the tenants and makes sure they have what they need. The investor works with the tenants if business gets slow.
Astute readers will note that the sale price was already adjusted for the needed capital investments (roof and parking lot) the other investments are not significant. Because prior management was less than professional, the value-added investor can wring savings from property expenses. Tax assessments can be appealed. Insurance and vendor services can be competitively quoted.
Perhaps even more importantly, the building has moved up a class and higher rents can be obtained upon lease renewal or tenant turnover.
A 20% increase in Net Operating Income can result in a 100% cash on cash return. Not too shabby for a formerly shabby property.