A value-add real estate deal is a type of investment opportunity in which an investor can increase the value of a property by making improvements or implementing changes. The goal of a value-add deal is to purchase a property that is undervalued or has potential for improvement, and then make changes to increase its value and generate a higher return on investment (ROI).

There are several methods for increasing the value of a commercial real estate asset, which include procuring off-market deals, leasing out vacant spaces, adjusting rental rates according to market value, and making capital expenditures for improvements.

In the realm of value-add real estate deals, the entry-level cap rate is not as crucial as the stabilized yield, provided that the debt can be serviced. The stabilized yield is calculated by dividing the post-renovation Net Operating Income (NOI) by the total cost. Our target is to have a spread of at least 150 basis points (bps) between the stabilized yield and the prevailing market cap rate in order to make worthwhile money.

As an example, suppose that the prevailing market cap rate for apartment buildings is 6%. Your broker presents you with a promising deal for a 10-unit apartment building, wherein the rents are currently below market value due to the property’s age and the landlord’s failure to increase the rent for the past decade. You agree to acquire the building for $10 million at a cap rate of 5.5%, resulting in an In-Place NOI of $550,000. Within the next 12 months, you invest $2 million in renovations and increase the rents of all 10 units to market rate. At this point, your stabilized yield is calculated as Post-Renovation NOI divided by Total Costs, which yields 8% ($960,000 / $12 million), reflecting a spread of 200 basis points (bps) between the stabilized yield and the cap rate. If you were to sell the property at the prevailing market cap rate of 6%, the property’s value would be $16 million, resulting in a profit of $4 million ($16 million – $12 million).