Avoid The Value-Add Buzzword

TruePoint Capital

The problem with buzzwords in the world of investing is that it replaces sound decision-making with irrational thought.

​​Remember the buzzwords that dominated last year? Crypto and meme stocks were generating a lot of investor attention along with their money. Flush with stimulus money, newbie investors flooded the markets, snatching up anything that was attracting attention on internet forums (i.e., Reddit) and social media. Investors snapped up crypto and meme stocks purely on buzz.

Dogecoin, a cryptocurrency that started as a practical joke, was flying high about a year ago. But, since its peak last summer, it has dropped more than 740%. Gamestop (GME), a meme stock that made waves last winter fueled by buzz generated on subreddit r/wallstreetbets, has fallen 167% since the peak of the hype last December.

If investors had put in their homework when analyzing the prospects of Dogecoin and Gamestop instead of solely relying on buzz, they would have realized that Dogecoin was a joke currency and that Gamestop’s momentum was fueled purely by artificial hype and not by any underlying economic factors.

If investors had done their research, they would have realized the Gamestop price spike was artificially created by a group of investors bent on teaching the hedge funds a lesson by combining forces to drive up the share prices of flailing companies targeted for short selling and causing hundreds of millions of dollars in losses when these hedge funds were forced to cover those shorts at high prices. Once the buzz died down, the crash was on.

In the world of real estate investing, there’s a buzzword making the rounds that make investors forget the basics of deal analysis and ignore the financial data and underlying economic fundamentals essential for projecting the prospects of a deal.

​​That buzzword is “value-add.” Like crypto and meme stocks, the word value-add invokes thoughts such as “can’t miss” that make investors act carelessly.

The problem with the word value-add is that investors assume the opportunity is a slam dunk when attached to any opportunity. However, in the wrong hands, a value-add investment carries high risk like any other investment. These investments are anything but “can’t miss.” They could lose investors more money than if they stuck with a more conservative investment strategy.

Value-add investments, when done right, can be a profitable and valuable tool for building wealth. As the name implies, a value-add opportunity is one where an investor can make substantive renovations to the asset or changes to management efficiencies and add value to an investment to generate higher returns than more conservative strategies like Core and Core-Plus opportunities that require little modifications to the property.

Investors acquire commercial real estate (CRE) for constituent cash flow and long-term appreciation. Value-add opportunities allow investors to boost both cash flow and equity through strategic improvements in appearance, amenities, and management efficiencies.

While value-add investments come with outsized upside, they can also potentially come with huge risks.

When Value-Add Becomes Value-Loss…

A value-add opportunity can potentially become a loser under multiple circumstances, including overpaying at acquisition or underestimating costs post-acquisition. Overpaying and cost overruns diminish the returns you once projected.

Value-add opportunities get all the hype, and everyone wants to get their hands on them. Still, there are two misconceptions to remember when evaluating value-add opportunities vs. other opportunities, including Core and Core-Plus:

  • Misconception #1 is that all risks associated with value-add investments are minor and can be overcome easily.
  • Misconception #2 is that other strategies such as Core and Core-Plus can’t compete with value-add assets.

Misconception #1.

The idea that all risks associated with value-add investments are minor and can be easily overcome is false. There are many risks – external and hidden – that can get out of hand and end up being prohibitively time-consuming or costly to remedy or mitigate.

Risks involved with value-add investments include:

  • Rehab is running behind schedule.
  • Overrun on material costs.
  • Unplanned labor costs and issues.
  • Disasters occur during renovations (e.g., striking a water main or gas line).
  • Natural disasters.
  • Troublesome tenants.
  • Unsavory elements are moving into the neighborhood or neighboring communities.
  • Not achieving target rents.
  • Unable to reduce vacancies or unexpected increase in vacancies.
  • Rehab costs exceed estimates.
  • Undetected foundational or structural issues.

Misconception #2.

Another misconception surrounding value-add opportunities is that they are the end-all-be-all of real estate strategies – Core and Core-Plus opportunities be damned.

However, when value-add properties get mired in problems, they’re no longer the values an investor once thought they were. A solid Core or Core-Plus opportunity seems relatively favorable compared to value-add properties caught in those circumstances.

So what’s the difference between core and core-plus properties vs. value-add?

  • CORE properties have high occupancy (90% or higher), generate stable, consistent cash flow from established, high-quality tenants locked into long-term leases, are located in prime locations, and require little to no upgrades.
  • CORE-PLUS is very similar to Core properties but offers the opportunity to improve cash flow through slight property, management, or tenant improvements.

When done right, value-add properties have the potential for generating above-average gains, and if they perform exactly as projected, they will out-gain other investment strategies.

​​That doesn’t mean investors should ignore Core and Core-Plus properties as well. They can prove valuable in any portfolio as a consistent and reliable cash flow source. Compared to underperforming value-add properties, Core and Core-Plus properties have the potential to outperform value-add properties but without the risks or headaches.

The success of a real estate investment comes down to deal analysis, data, and numbers. It doesn’t matter which strategy you pursue. If you rely solely on buzzwords and fail to do your homework, your investment will fail. On the other hand, if you dot all your i’s and cross all your t’s, you can make money from any strategy.