Value-Add Commercial Real Estate

Many of the most interesting real estate investment opportunities involve “value-add” situations — renovation or redevelopment projects that aim at repositioning a property to a higher price point.  The value-add strategy is often considered to have medium to high risk, but the returns can be potentially high as well.

Value-Add Opportunities Generally

“Value-add” opportunities may arise from an operational strategy of increasing revenue, lowering operational expenses, or any other approach that effectively repositions a property so as to realize a valuation gain based on the resulting increased net operating income (NOI).

Sponsoring real estate companies in the value-add sector are generally in the business of acquiring, developing, constructing, or otherwise rehabilitating real property where that “sponsor” sees an opportunity to reposition a property to a “higher and better” use. The value-add improvements made to a property can often lead to a “re-grading” by the market (i.e., potential tenants) of that property’s quality, as a result of any increased NOI — whether from greater occupancy rates, higher rental rates, or reduced expenses. Lender financings follow suit – some value-add projects re-finance themselves and then continue to distribute returns to partially paid-off equity holders – so that investors can potentially continue to earn returns with even less investment capital at stake.

In some cases, a value-add approach can refer to the purchase of poorly leased properties, or those with substantial near-term lease rollover – in either case, where current valuations can be compared to those of market (or replacement) costs.  The follow-on renovation, or repositioning, brings those properties to a “stabilized” – or “at market” – status.

Comparing to Other 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.

More About Value-Add Investing

A value-add strategy is distinguishable from other real estate investment strategies in that it relies on relatively greater leverage, increased reliance on renovation or development, and a focus on secondary markets.  The increased risk attributed to value-add properties is often caused by the construction risk associated with such properties. Light renovations can include property enlargement, capital improvements (e.g., new roof), refinishing of interiors or certain structural repairs, while more significant redevelopment efforts can include a major overhaul of the property or its conversion into a different use (e.g., warehouse converted to multi-family apartments).

Construction risks include the possibility of higher-than-expected costs (financing, materials, or labor) and uncertainty about the future economic environment – whether the then-current market rates upon the property’s completion will support the costs incurred by the construction. There is also some re-tenanting risk; re-tenanting opportunities can serve to increase cash flow when existing rents are below current market levels, but also present a risk if the Sponsor finds it to be unexpectedly difficult to find new tenants. Finally, value-add opportunities may rely more heavily on “total return,” as opposed to solely current yields, since price appreciation is often a key component of a sponsor’s strategy.

Value-Add’s Increased Potential Returns — But With Higher Risk…

“Value add remains the favored strategy for raising and deploying capital,” recently said JLL (a global commercial real estate services firm) in its Q3 2017 U.S. Investment Outlook.

Since “trophy” real estate seems to be already highly priced, some observers see non-major markets and non-core properties as presenting an opportunity for savvy investors.  “Follow the jobs,” said JLL in its recent report on middle-market investing.  “Second-tier cities are [also] boasting strong job growth in absolute numbers (e.g., Dallas, Atlanta, Phoenix, and San Diego).”  The report continues to state that “We believe strong risk-adjusted returns can be earned by segmenting the market based upon asset size in addition to geography… [because] “with so much capital to deploy, these $1+ billion mega-funds must remain focused on the larger transactions…”

The value-add strategy involves greater risk (compared to core or core-plus approaches) via its heightened reliance on greater leverage, renovation and/or development, and a focus on secondary markets.  Yet this same refurbishment, or enhanced management, of a property can often lead to a “re-grading” of the property’s quality by the market (i.e. potential renters), and thus to increased revenue.

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 can sometimes be less development competition there.  The re-tenanting opportunities can serve to increase cash flow when existing rents are below current market levels, but they also present a risk element since it could be unexpectedly difficult to find 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.

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 multi-family apartments).

The Way to Play in Real Estate Today?

Value-add strategies have become increasingly popular, now that the Great Recession has largely 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 becoming 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 Messrs. 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.”

Some observers believe, too, that smaller private equity real estate funds are a particularly attractive way to build wealth.  According to HuffPost and Preqin (an investment data firm), a review covering private equity real estate funds making first investments between 2005 and 2015 showed that real estate equity funds with more than $1 billion or more in assets had an average net internal rate of return (IRR) of 5.7 percent – while funds with less than $200 million in assets experienced a net IRR of 11.2%.

Potential Tax Advantages

Pass-through investment vehicles (such as LLCs used by by marketplaces like RealtyShares for equity investments) not only avoid double taxation but also allow investors to potentially obtain the full benefit of any available tax losses or incentives.  With real estate, the magnitude of the depreciation and interest expense deductions make this advantage potentially significant.  The pass-through structures of LLCs allow partners/members to receive “flow-through” of these tax offsets, and to thus receive periodic distributions without incurring (much) current taxes.  Investors may ultimately have some or all of this tax benefit be “recaptured” by tax authorities upon a sale or other disposition — but in the meantime, they can have tax-free use of the distributed cash.

Risk Factors for Private Direct Participation Vehicles

The direct participation vehicles discussed above still carry significant risk. All of the investments offered by RealtyShares are private offerings, exempt from registration with the SEC, and the disclosures are less detailed than would be expected from a registered public offering. Ongoing disclosure requirements are negligible. The investments are also illiquid, with undetermined holding periods and no real preset liquidity terms. These offerings are also only available to accredited investors, so the illiquid nature of any investment is heightened – further emphasizing the differences of these securities compared to registered, publicly-traded securities.

Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied.  Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

Lawrence Fassler
Corporate Counsel
Lawrence has over 15 years' experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.
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