Apartment investors generally employ one of four investment strategies when analyzing an opportunity. Core, core-plus, value-add and opportunistic are the four quintessential investment strategies in the commercial real estate investment market.

Understanding each strategy helps newbies and more seasoned investors determine their real estate investment risk profile. The more leverage the more risk. For conservative investors, high quality properties with low leverage is the route, while those on a longer timeline may want to assume more risk and higher leverage. While every investor is unique, comprehending the four real estate investment strategies will help to ascertain risk tolerance and the best approach for real estate investing.

While these four investment strategies are important to understand, investors active in the single-family rental and small-unit rental market will often come across value-add opportunities. It is one of the most common strategies in the small asset market. To make these deals pencil as an investment—in other words, to ensure that you buy the property for a price that allows for a profit—many properties in this category will need to be purchased below replacement cost with necessary capital improvements.

What is Value-Add?

When an investor thinks value-add, they think growth. Investors engaged in value-add investments assume higher risk with an expectation of greater returns and security down the road. Investors partial to value-add property investments see a chance for resilience not so apparent at first glance. Generally, value-add assets are flawed properties in need of capital improvements. Assets of this class are usually distressed, purchased at a discount and present challenges, including low occupancy, mismanagement and deferred maintenance—or a combination of these shortfalls.

While these properties need further investment, they also offer a value proposition with the potential for strong occupancy and rents once the capital improvement plan is completed. Overall, they present an opportunity to produce significant cash flow.

The Risk of Value-Add

Value-add investments aren’t the highest risk investment strategy—an award that belongs to opportunistic or distressed asset investing—but it is a moderate risk investment proposition. Investors venturing on this moderate-risk road must weigh market fundamentals, strategic planning comprised and project management. While this investment model does increase the rate of return, it also increases the risk and is more sensitive to a real estate cycle downturn.

Generally, value-add investments require higher leverage or a higher up-front equity investment to pull off. These funds will cover purchase costs as well as renovation costs. This means that there are little funds at the outset and a tight budget, and the investment is initially is rife with debt financing. Investors executing a value-add strategy should anticipate high leverage in the 40% to 70% range.

Despite these higher upfront costs, a value-add strategy is rewarding. Value-add investors tend to net a 10% to 15% return on investment.

Inside the Value-Add Strategy

Successful value-add investors deploy a thorough plan. This includes extensive research on market values for a well-maintained property, occupancy rates for the surrounding micro market, standard apartment amenities for the area—Do most apartments have in-unit laundry or stainless steal appliances?—and the local market rents. These details will help you understand the potential NOI for the asset once the value-add plan is implemented.

Market data is only one half of the value-add business plan; renovation expenses are the other. Seasoned investors might already have a good understanding of materials and construction costs and may even have a reliable contractor or subcontractor on hand. Newbie investors, on the other hand, will want to do extensive research on total renovation costs during the due diligence period. In fact, you might consider bringing licensed subcontractors or a contractor for an additional inspection during the escrow period to have a thorough understanding of the repairs needed and the condition of the property. Contractors and subcontractors will give you a more in-depth analysis of the property than a basic inspection.

Understanding these costs along with the potential NOI will help to properly underwrite and price the asset.

Breaking Down the Return

Generally, the cap rate would be the go-to metric for initial investment analysis; however, on a value-add investment, the cap rate can be misleading. The NOI and the purchase price—the two key metrics in determining the cap rate—will not reflect the market standard. For that reason, a cash-on-cash return is often a better metric to get an initial understanding of the return on a value-add investment.

A cash-on-cash return measures the full cash investment, including renovation costs, as well as the debt on the asset, which as mentioned earlier can be substantial on a value-add investment. The formula will give you a better understanding of the return including the total investment cost, which a cap rate does not.

In addition, value-add investors can calculate for a projected cap rate, based on the estimated market value once renovations are complete and the estimated NOI once the property has stabilized. Keep in mind this will be an estimate, as market fundamentals can change based on economic conditions.

While considered moderately higher risk than a stabilized core asset, value-add investment strategies are common, particularly in the small asset market, and it can generate strong returns.