Passive Investing in Active Value-Add Real Estate

The Different Approaches to Real Estate Investing

Private real estate investments are often grouped into one of four broad categories:

Core: Generally considered to be a lower-risk/lower-return strategy, this approach uses relatively low leverage and focuses on stable, fully leased, multi-tenant properties within strong, diversified market areas. The properties generally do not require significant enhancement or renovation.

Core Plus: This approach also focuses on core-like properties, but with an increased opportunity for improving the property’s net operating income through modest measures such as increasing the rents upon lease rollovers or by effecting modest property enhancements. It’s generally considered to be a moderate-risk/moderate-return strategy.

Value Add: This is thought to be a medium- to high-risk strategy generally involving making relatively significant improvements to a property so that the market will assign a higher value to it. Properties are considered candidates for a value-add strategy when they exhibit management or operational problems, require physical improvement or suffer from capital constraints. This approach may offer medium to high potential returns.

Opportunistic: This is a high-risk/high-return strategy involving development projects, the redeployment of markedly underutilized properties or other extensive enhancements.

Value-Add’s Increased Risk—for Higher Potential Returns?

The value-add strategy involves greater risk than core or core-plus approaches by relying primarily on greater leverage, increased reliance on renovation or development and a focus on secondary markets. The refurbishment or enhanced property management can often lead to a “re-grading” of the property’s quality and thus to increased revenue.

Any construction element of a project involves increased risk. These risks include the possibility of higher-than-expected costs (financing, materials or labor) and the uncertainty about the future economic environment (will the then-current market rates support the costs incurred by the construction?). Lesser renovations can include property enlargement, significant capital improvements (e.g., a new roof or lobby), refinishing of interiors or certain structural repairs. More significant redevelopment can include a major overhaul of the property or its conversion to a different use (e.g., a warehouse converted to multifamily apartments).

Value-add properties may also be located in secondary or tertiary markets, which can be somewhat riskier than primary markets since, all else being equal, primary markets are more desirable for tenants and there is less development competition there. The re-tenanting opportunities can serve to increase cash flow when existing rents are below current market levels, but also present a risk element since it may turn out to be unexpectedly difficult to find such new tenants. Finally, value-add opportunities rely more heavily on “total return”—as opposed to just current yields—since price appreciation is a key component of the strategy.

The Way to Play in Real Estate Today

Value-add strategies have become increasingly popular now that many feel the worst of the “Great Recession” has passed.“While 2008 through 2011 was largely an ‘era of acquisition’ in which lucrative opportunities were abundant for anyone with available capital, we are now in an ‘era of execution,’ in which investors must create value and execute strategically to achieve attractive risk-adjusted returns,” according to P.J. Yeatman and Jeffrey Reder, private real estate executives for CenterSquare (formerly Urdang Capital Management).

If stabilized core assets are now substantially fully valued, some observers believe that “total return” assets—like value-add real estate opportunities—are relatively underpriced. The real estate cycle may have reached a point where investors can create arbitrage from the “mispriced perception of risk” that exists between stabilized core and value-added assets, the CenterSquare executives said.

“Due to the combination of a high cost basis and a lack of opportunity for increased yield, stabilized core assets carry greater risk than is currently perceived,” said Reder and Yeatman. “In contrast, transitional value-add assets can be acquired at an attractive cost basis in today’s market because they are perceived to carry greater risk.” In reality, cost advantages created through redevelopment provide superior downside protection and less actual risk, they said, adding that acquiring middle-market assets through a value-add strategy now “represents the best opportunity for creating value and reducing risk.”

The strategy requires significant market expertise, however. In L.A.’s hot Westside area, for example, the rising demand for low-rise collaborative office space coming from creative-focused entertainment, design and software companies has resulted in opportunities for investors and developers with enough local market knowledge to acquire and reposition older Class B and C office buildings.

“Value-add attracts a certain type of office, retail or apartment investor or developer, one who is incredibly astute and in tune with the local market needs,” said Martin McDermott, a Los Angeles-based investment broker with Avison Young. “It flexes their real estate experience. Investors are looking at local market information, factoring in the cost of construction and the process, and determining whether they see a higher and better use than what currently exists.”