Do you wonder how real estate investors can find these steeply discounted deals and then make incredible returns on the sale of the asset? Well, if you are familiar with real estate investing, you know this as the value-add strategy. 

You’ve probably caught a show that glamorizes the “fix and flip” version of value add. Hotshot designers come in to help the Jones Family take a junker house and transform it into a remodeled, modern sanctuary. Complete with all the bells and whistles. This is a type of value-add real estate investing. 

In this blog, we’re going to break down the 3 keys to the value-add strategy in real estate investing with a particular focus and an example on how we implement these strategies in Note Investing. 

The 3 keys are:

1. You have the knowledge to identify assets with the potential to increase value but aren’t worthless (think minor rehab vs. full tear-down), 
2. You purchase the asset below market value
3. You have the knowledge, skills, or funds to improve the asset.

What is Value-Add Real Estate Investing?

Value-add real estate investing is when you find an asset, typically a house or property, that needs some improvements. With these improvements, the value of that house will increase. 

A savvy real estate investor would analyze the numbers to see that paying a contractor to rehab the kitchen and paint the walls will allow you to get a much higher rent or even a bigger sales price. You’ve added value with smaller efforts that yield a bigger increase in overall asset value.

The key here is the difference between what you put in and what you get out. 

The most lucrative value-add comes from when you put in sweat equity (not capital). It is all a financial equation. Real estate investors often love these kinds of assets or properties because the numbers can work out such that a small improvement will yield a bigger return. 

The Note Investing Value-Add Strategy

When you invest in a Note, you become the lender or the bank, and the owner of the property pays you every month. Your investment consists of the loan documents and the mortgage or deed of trust. The house is the security on your investment. That’s the Note. 

Notes can be one of the purest forms of passive monthly cashflow because you are working with owners and not tenants.

The value-add strategy in Note Investing involves finding Non-Performing Notes that need a little work. You – or your partners – put in the work to essentially force appreciation and create a performing note. Then, you sell the Performing Note for a higher value. It’s like the fix-n-flip of the note world. 

Let’s dive deeper with an example and use the 3 keys to the value-add strategy to see how we can get some great returns (and help someone keep their home).

Let’s say you purchase a Non-Performing Note for $50,000, which includes expenses for note analysis, monthly servicing, and a reserve fund in case of foreclosure. You do your research and see that the property is worth $80,000 as-is. You also see in your extensive due diligence process that the owners likely want to keep their home, even though they haven’t been able to make payments recently (that’s why it’s a Non-Performing Note).

Key 1: You Can Identify An Asset With Potential To Increase In Value

Our first key is that you have the knowledge to identify an asset (a Note in this case) that has the potential to increase value. You’ve found a $50,000 note that is secured by a house that is worth $80,000 as-is. You’ve also determined that the borrower may want to work out a new payment plan to keep their house. You also have the knowledge to assess the quality of the paper trail in the loan documents. You can see that there are no missing recordings or crazy liens that would impact your expenses. 

Assessing the property, the people, and the paper in your due diligence means that you have the knowledge to identify a value-add Note asset. (And thanks to Tracey Z for the three-P acronym there.)

Key #2: You Can Purchase Asset Below Market Value

The second key is that you purchase the asset below market value. You and your team are able to do this because of your relationship with the seller and your negotiation skills. 

While our example note costs $50,000, the actual balance due from the borrower is $90,000. With a property worth $80,000, the borrower is underwater. Because you know the actual value of the securing collateral and that the borrower isn’t making payments, you aren’t going to pay full market value ($90,000 in this case) for this Note. 

You leverage your knowledge and have built a strong relationship with the seller. Because of this, you can purchase the note for only $50,000. That is only 55 cents on the dollar. We call that an equity cushion. We have incredible flexibility to add value and the security of knowing we can still get a great return if we have to take back the property and sell it as-is.

Key #3: You Have The Knowledge, Skills Or Funds To Improve The Asset

The third and final key is that you have the knowledge, skills or funds to actually put in the work to improve the property. 

For our Note example, you know the details to find in the stacks of paperwork that come with the Owner and Encumbrances Report. You know how to evaluate the fair market value of the property. You know what to look for in the borrower’s credit report and servicer comments. Or, you have a partner who knows how to do this. In fact, this is how most people invest in the value-add strategy of Notes. 

The due diligence here is incredibly detailed and you can make some serious mistakes if you don’t know what you are doing. Investing in a fund or a partnership is a win-win relationship. Operators, like us at Flow State Investing, can access steeper discounts when working with partners. Therefore, you can still take advantage of the great returns possible in this value-add real estate strategy asset class.

Implementing The Value-Add Note Investing Strategy

Let’s sum it up. The three keys to the real estate investing value-add strategy you or your team need to have are: 

1. Have the knowledge to identify assets that have the potential to increase in value, 

2. Have the relationships and negotiating skills to purchase the asset below market value

3. Have the knowledge, skills or funds to improve the property or asset.

If you are interested in accessing the value-add strategy in Note Investing, join our Flow State Investor Circle. It’s free to join and will give you access to more education and information about growing money through the value-add strategy in Notes. We’ll schedule a call to discuss your investing goals and whether a Notes partnership or fund may be right for you.