What Makes a Value Add Property a Great Real Estate Investment?
Everyone understands that when you fix something up, generally, you increase its value. When you apply this to private equity real estate, this is called value-add investing.
In business, value-add refers to the extra features a company gives its products that go beyond standard expectations, such as free maintenance, training or warranties. These features can give goods and services a competitive edge that lets companies charge more for them — and inspires customers to pay those higher costs.
In private equity real estate investments, value-add goes beyond product differentiation. Fund managers spend money to support physical or operational improvements that enhance a building’s value.
To succeed at this strategy, it is critical that fund managers have deep knowledge of a property’s physical condition, it’s competitive positioning with the marketplace, cash flow and leasing prospects, as well as acumen about the underlying risks and rewards improvements will have on the overall investment performance.
For investors to make wise decisions about a value-add investment opportunity, they must understand its potential risks and rewards, especially as it compares to other types of investment strategies, which include Core, Core-plus and Opportunistic.
Value Add Real Estate Investments
In private equity real estate investments, value-add holds the middle ground between core and opportunistic investments. All have specific profiles for income stability, capital requirements and appreciation prospects.
Value-add properties may have operational issues and require physical improvements, either due to neglect or owners lacking the capital to make improvements. Buildings in this bucket are usually between 50 to 80 percent leased, but can be more lucrative with the right kind of physical upgrades, better management, added services or more effective marketing.
These changes add value beyond routine physical upgrades, and can attract new tenants, improve retention of existing tenants and generate higher rents from both segments.
So how do we find quality value-add deals?
We look for properties with trapped value — either physically, operationally or structurally. A structural trap can be from a debt (leverage) standpoint or related to partnership issues within the existing ownership.
Once we identify the property, we create a business plan to maximize value and then we settle on the right price based on the cost, risk and timing of our turnaround plan.
Watch Michael Episcope explain a few of the ways value add properties can be evaluated.
From there, it’s critical we find the best property management firm to execute the business plan.
One of our most compelling value propositions as a fund manager is that we focus solely on asset management and hire the best third-party service provider based on the specific business plan, property type and market. If you are vertically integrated and also provide property management, project management and construction management, it makes it very difficult to fire yourself if you aren’t performing. We are structured by design to avoid that conflict.
One of other competitive advantages is having flexible investment capital. Financing needs often change in the course of a project. A firm with multiple funding sources adds value by reacting quickly, putting in place the right financing structure to meet the needs of the business plan and even injecting funds to keep a schedule on track. For instance, we have and can inject new capital to pay off debt, which gives us time to put in place a new value-add program to maximize revenue.
1. Core or Core-Plus Real Estate Investments
A core or core-plus property has all the earmarks of stability: a prime location on well-maintained grounds in a major market, full of tenants happy to sign long-term leases at top prices. For a landlord, what’s not to like? This profile fits in a blue-chip portfolio, one that offers a steady stream of income and little downside risk.
The offset of this stability is that these types of investments generally do not offer much potential for growth. While the right manager can improve returns on even stable properties, the prospects for growth increase when investors fund improvements that can justify higher rents.
2. Opportunistic Real Estate Investments
On the opposite end of the investment spectrum is an opportunistic real estate strategy. These deals involve buildings that require either massive turnarounds or raw land upon which one builds.
While there’s more risk because of the high, upfront costs, there can be high rewards.
New construction ultimately might deliver a core property and attract high-profile tenants. However, getting there takes years of labor and management intensive development and substantial market risk before the first rent check is collected. Given these risk characteristics, we have a very high threshold to meet before we would consider these types of investment opportunities.
At Origin, we’re very comfortable playing in the middle of these two extremes but also have the investment discipline and experience to identify select opportunistic / development opportunities that help create a diversified portfolio with strong risk-adjusted returns.