Value-add, often called opportunistic, investments are a way to breathe new life into existing real estate. By redeveloping, repurposing or performing adaptive re-use on properties that have become tired and/or obsolete, developers can create brand-new, desirable assets in supply-constrained markets that are craving new inventory and also generate greater profits for their investors. The practice has become a way for ever type of investor from REITs to high-net-worth individuals to achieve the yields they seek in heated markets that have become overrun with domestic and foreign capital, which has forced prices up and compressed cap yields. It’s also become nearly the only type of development seen in markets where developable land is scarce and expensive, such as most of Southern California. When core assets are out of reach or simply don’t make sense, value-add plays are a smart alternative for yield across all property categories – so much so that many commercial real estate investment and development firms are focusing primarily on these opportunistic ventures over core assets.
Value-add investments can be made in property, funds and joint ventures, providing a wide menu of choices with almost immediate payoff once the renovations are complete. “Value-add and opportunistic investments offer the chance to get near-term double-digit returns, which is now almost impossible with stabilized commercial real estate assets,” Solomon Poretsky, VP of organizational development for Sperry Van Ness International Corp., tells Real Estate Forum. “While they’re perceived as riskier than stabilized properties, assuming that the value is there to add, they actually provide important downside protection since, if value do drop in the future, they could still end up with a net gain. For example, a $20-million asset that has $10 million in value added and then loses $8 million in a correction is still worth $22 million (20+10-8) – a 10% increase. a $30-million stabilized asset that loses $8 million in value in a correction ends up losing about 27% of its value.”
For Carter, a real estate investment, development and advisory firm, there has always been an appeal to opportunistic investments because of a higher adjusted return, Jim Shelton, the firm’s vice chairman, tells Forum. “Obviously, if you are buying core returns there are lower yield expectations, but as you evolve to core-plus, value-add and opportunistic investments, each has a higher risk profile and theoretically pays a better return. Typically, you see investments in this category with investors wanting to diversify and climb up the risk spectrum to improve yield.”
Some property types that are in high demand – industrial, for example – draw investors to opportunistic investments. “Nearly all investment funds are under-allocated to industrial real estate, and there is a wall of capital trying to get into California industrial due to its perceived safety as an investment class within the broader real estate market,” says Jon Pharris, co-founder and director of acquisitions for CapRock Partners. “With industrial cap rates around all-time lows, value-add and opportunistic acquisitions allow capital to diversify within industrial real estate and pick up additional yield with only a slight increase in risk. It is a favorable trade-off.”
In fact, first and foremost, investors seek value-add and opportunistic investments as yield generators, Robert Dougherty, partner at Buchanan Street Partners, tells Forum. “For better or worse – leverage being a double-edged sword – real estate presents a unique asset class in this regard compared with other opportunistic investment strategies (e.g., M&A activities, corporate investments, etc.) because real estate investments are underpinned by hard assets. This offers the prospect of favorable leverage ins pite of substantial value creation left to implement. Naturally, the same downside protection afforded by real assets that the lenders seek favors the investor as well – provided that investments are not over-leveraged. The debt markest appear to have a more active governor in this cycle vs. the last. Regulators and B-piece buyers are keeping debt underwriting sane, saving opportunistic investment managers from themselves – so far; at least.”
Value-add investments also appeal to an investor/developer’s creative side, which has become the buzzword of choice in new development. “The appeal to a purchase of a property that has a value-add play is the opportunity to get creative and add tenants, update the facade, build and outparcel, etc., to increase the NOI from when the property is purchased so that when they go back to market to sell the property, the price increases,” relates Bryan Belk, director of Franklin Street Real Estate Services.
Many funds like the diversity that value-add investments offer them. Waterton Associates, for instance, is on its 12th value-add multifamily investment fund and is currently actively investing that fund, CEO and founder David Schwartz tells Forum. “The advantage for that type of vehicle is that they are geographically diverse. We will buy 35 properties, and they will typically be in 15 different markets. We curate our portfolios – we generally don’t buy portfolios unless we like all the properties – and the properties range from deep value-add (adaptive re-use or stalled construction projects where we’ve completed them and built out the units) to light value-add where we may update kitchens and common areas. You get some higher-risk, higher-reward assets and some lower-risk, lower-reward assets, and it’s a nice combination, but at the end of the day, the portfolio should have great locations and be good real estate.”
Often, opportunistic investments are most popular during and immediately after a recession, economic downturn or low end of a real estate cycle, but how to they fit in at other points of the cycle? “Value-add is usually popular during and right after recessions because it’s easy to do,” says Poretsky. “Good buildings that fall on bad times are usually great acquisitions, and all that the owner has to do is wait for the right time to extract the value that he or she adds by stabilizing the asset. In good times, it can be harder to find a distressed asset, but, if you can find one, it’s that much easier to extract the value. Ultimately, there are always opportunities to create value in the market.”
The challenge has always been predicting where exactly in the economic cycle we are, and that can be difficult, says Shelton. “The later you go in the cycle, the harder it is to find value-add opportunities, which means that you’ve got to be more creative to achieve the returns you desire.”
Pharris says in any cycle there are value-add acquisitions, “but the nature of the opportunity changes as the recovery advances. Early in the recovery, the value-add may be REO or non-performing notes; then it can progress to partially occupied buildings or short-term leases; and then it may advance to buildings with excess land or converting non-functional buildings to higher an better uses. The key is with that there is always opportunity but it is imperative to know the state of the cycle. so that the investment thesis can adjust.”
True value creation activities such as lease-up, renovation, rebranding and repurposing should offer enhanced yields regardless of the market cycle, says Dougherty. “Too often, however, merely riding a market wave or exploiting cheap debt is accepted as ‘value-add’ activity.”
Belk, too, believes value-add activity is always popular no matter what part of the cycle we’re in. “Investors are always looking to increase the value of their portfolio by looking for assets where tenants’ rents may be under market or spaces may be better used for other tenants that have a positive effect on the value of a shopping center.”
Schwartz disagrees that value-add plays are more profitable during or immediately after a recession. He adds that investors can often get better prices on value-add investments at those points in the cycle, but it can also be more difficult to lease up renovated apartments and achieve desired rent growth when the economy is depressed. “[Buying at low prices] is the opportunity. But ironically, renovating units out of a recession can be tough because no one really wants to pay the rent [on an upgraded apartment unit]. In 2010, people were willing to accept units the way they were, so value-add didn’t work everywhere. At that time, we weren’t doing renovations in all markets because you couldn’t get the premium. Fast-forward to today, when the market is extremely strong, and you have a record disparity between new and old product – the rent differential between new and old product is as high as it’s ever been recorded. So, in the strong part of the cycle, you’re getting much better return on dollars invested in value-add. We think the market is very good now, and when you think about it, when you renovate an older property in a good location and the rent is $400 below new construction, it’s a great value proposition for the market, and there’s a lot of demand for it.”
Despite the upside, there are some common mistakes investors in value-add make that can curtail their success and drive down profits. “The key to opportunistic investment is in due diligence,” says Poretsky. “Returns are largely locked in the day that you buy the asset. If you don’t know what you’re getting into and end up with delays, unexpected costs or unforeseen challenges in tenanting the property, the property goes from ‘opportunistic’ to ‘mistake’ very quickly. The more up-front research an investor does – especially leveraging local market experts from the brokerage community – the more likely the deal is to hit projections.”
Shelton says in the later stage of an opportunistic environment, from an underwriting standpoint people tend to become too aggressive with debt and end up overpaying and overdeveloping. “They may also venture into areas where they don’t have as strong a level of experience.”
Pharris says being over-leveraged is one of the biggest mistakes made in opportunistic investments, and Dougherty agrees. “Far and away, the biggest mistake made with opportunistic investments is over-leveraging them. It is ironic that many investment managers and their clients have their leverage strategies backwards. They over-finance the riskier, more volatile value-add/opportunistic investments and don’t borrow significantly against their safer core assets.”
Schwartz says some investors make the mistake of paying more than reproduction cost for value-add assets just to get in the game. “Why would you buy a value-add property that would cost you more when you’re done than a brand-new asset? It makes no sense to me, but you’re seeing it. It makes no sense to me, but you’re seeing it. It’s the valuation issue you have to be careful of – it’s difficult to find good, well-located property and buy it below replacement cost, but that’s what we look for to buy.”
Underestimating the cost of doing value-add is another frequent misstep, says Schwartz. “This comes from not properly conducting due diligence and figuring out what it costs to do it right. I see so many value-add renovations done on the cheap, but the customer – the resident – is very smart. When they see a renovated apartment done with cheap materials, poor quality and workmanship, they’re not going to want to pay for it. Some people skimp out on quality and overly value engineering, and the customer doesn’t go for it. And often, with older assets, they’re not looking behind the walls enough to find problems in plumbing and electrical. You get no return on that capital investment, but you still have to spend the extra money, and if you miss those they’re a killer.”
Another common mistake is seeking yield in tertiary markets, says Dougherty. “The timing of these plays is extremely dicey. They are last-to-rise, first-to-fall markets, and their ‘day in the sun’ for institutional liquidity is often a short, unpredictable window.”
Belk says not doing proper research on a market is a huge mistake investors make in their search for yield in value-add investments. “Many times when investors see vacancies, they think opportunity. A lot of times there is a very good reason why a space is vacant; i.e., the submarket is shifting or a traffic pattern is changing.”
Creating improper alignment of interests is another frequent pitfall in value-add investments, Dougherty says. “Capital partners can find themselves at odds with operators with too little skin in the game and a fee revenue stream to protect. This can lead to misalignment of fiduciary responsibilities. Complex financial structures may have the same impact when one party ends up out of the money unexpectedly vs. a pari passu arrangement.”
Paying less for a value-add asset than you would for a core property is no excuse for poor due diligence and imprudent real estate practices. Making these mistakes can erase any gains investors might have made in these plays, but approaching them wisely can yield great results.