The Best Real Estate Isn’t Always the New and Shiny Asset

Jan 8, 2018

Adding value to underperforming commercial real estate is an investment strategy often overlooked by those unfamiliar with the industry.

After all — as with technology — wouldn’t you want to invest in the newest and best in the market? Why not buy a recently built residential high-rise or an office building in a city’s central business district?

Those investments are by no means bad ideas. But in many cases, they don’t always offer the best returns. There is a lot of competition for trophy buildings by REITs, institutional investors, and others, with very deep pockets, looking to hold long term.

On the other hand, investing in a building that might not be the most visible in the market — perhaps even overdue for an update — can provide much higher returns. For example, many tenants are attracted to vintage buildings, due to their historical charm. Even after a significant renovation, their leases will likely cost less than what they would pay in the newest building on the block.

But there is a risk-return that investors need to weigh. You don’t want to just target any blighted commercial real estate property out there, hoping that a cosmetic renovation will automatically up its value and draw a pool of buyers.

If an investor wants to make money in value-add, there are some simple ground rules to follow to enjoy the successful returns that these properties can provide.

Location, Location, Location

A company can renovate a building into the nicest commercial real estate asset in the country, but that doesn’t matter if it’s in a location where tenants aren’t interested in committing to a lease.

Think of it as the opposite of a diamond in the rough. There are certain commercial real estate assets that often get overlooked because they might be older and dilapidated, but the locale is excellent. These investment opportunities don’t even have to be that old. Sometimes buildings built in the 1980s or 1990s are poised for a value-add renovation depending on how past owners have taken care of them.

Certain areas of the country have also seen unpopular neighborhoods quickly transform into the trendy spot to be. Downtown Los Angeles, for example, was once considered a less-than-desirable place to live and do business, but is now experiencing a commercial real estate boom.

People will always want to live in Southern California, and Florida is similar, boasting an exponentially expanding population, as well as job growth. Macroeconomic trends in a metro area can give an investor an idea of what drives commercial real estate demand.

If a purchaser can find an overlooked asset in similarly in-demand locales, then returns could be fruitful, with internal rate of returns as high as 17 percent after holding the asset for a few years. And that’s before exiting the deal and realizing a major boost to value from appreciation and increased net operating income (NOI).

Spend Money to Make Money

High returns don’t come without a price.

It takes a lot of funds to gut renovate an older apartment building in a sought-after suburban or urban community renters want to call home.

Specifically, in the case of multifamily, today’s renters expect a highly-amenitized experience compared to prior years. It’s not enough nowadays to make sure a tenant has sufficient storage space.

More and more, rental housing is becoming like the hospitality sector of commercial real estate. High-speed Wi-Fi, stone countertops, bathrooms with the most up-to-date fixtures — not to mention common-area amenities that include dog parks, gyms and workout facilities — are considered the norm. And forget chipped paint and unkempt landscaping if you’re trying to attract renters.

Then there are the building and engineering systems that residents typically don’t even think about. Roof repairs, HVAC upgrades and plumbing might all need some allocated dollars as well. All this work comes at a price that does not come cheap. For example, in a sought-after area of San Antonio, the renovation of a single unit can cost upwards of $12,000 to get it up to par by contemporary standards if it was built in the 1990s.

Value-add does not end after renovations are complete. Equally important to the physical upgrades is property management, which plays a crucial role in the success of a property. Successfully managing an investment property is just as complex as running a business. That means it requires a specific skill set and experience. Many assets fail because poor management resulted in major issues such as long-term vacancies, shorter tenant retention or expensive maintenance issues, just to name a few. All this will impact the overall return on investment and holding period of an asset.

Finally, now that all these improvements have been made, these assets will need proper branding to rectify the reputation damage the property may have encountered.

Pick the Right Partner to Ensure NOI

Picking the right partner is one of the most important things that an investor new to commercial real estate can undertake.

What they can provide, if the right one is chosen, is guidance on a local market’s up-and-coming neighborhoods and what tenants might prefer in those areas. Or maybe your partner has experience in operational overhauls and a good network of skilled local contractors to execute the scope of work on time and budget.

CCIM, a professional commercial real estate trade group, suggests how to choose the right firm to manage an investment asset once purchased. Their message is that quality firms will be very conscious of your NOI and how to keep it favorable. The ways they do this well is by consistently, front-and-center, managing tenant relations; making sure upkeep and general maintenance are done on a regular basis; and providing a service that lets an investor transparently know the financial ups and downs of an asset.

But the good news is, as much work as it can take, there are developers out there looking for more casual investors to provide funding to fill the cost gaps to improve a property. And if that works out, someone putting just $25,000 toward a project’s success could double their money in just a handful of years.

Like everything else, investing in value-add commercial real estate is a gamble, but if you execute the proper due diligence, and expect to spend money to make money, the returns could prove fruitful.