A recent report by CenterSquare Investment Management argues that the search for value in real estate has shifted to a new phase in which investors must create property value through astute leasing and management to achieve better risk-adjusted returns.
“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).
Since 2009, investors have largely flocked to acquire stabilized core assets to the point that Yeatman and Reder believe current yield is now overbought and total return assets are relatively underpriced.
With improving fundamentals spreading across more markets, the real estate cycle has 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,” Reder and Yeatman wrote. “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.”
CoStar transaction and analytical data bears out the investment market shift. Core properties in major markets have now risen to within 5.5% of their previous 2007 peak, while pricing in smaller transactions is still 25% below the prior peak, leaving a longer runway for price appreciation and yield in secondary markets and lower end properties, according to the most recent CoStar Commercial Repeat Sale Index (CCRSI).
The spread between capitalization rates in core markets and the risk-free interest rate has narrowed over the last year, and with rates projected to rise, investors will likely search for yield by acquiring and adding value through repositioning in secondary assets and properties in second-tier market.
Rise Of the Value-Add Funds
While core property investment is still of keen interest to investors, higher risk strategies are now getting more attention and have dominated capital fundraising over the last year. As of January 2014, there were 451 closed-end private real estate funds in the market targeting $151 billion, of which 64% of the funds are following either an opportunistic or value-added strategy, according to private-equity research firm Prequin.
Opportunistic funds accounted for 46% of all raised capital with 54 funds raising $35 billion over the last year, while 50 value-added funds closed after raising an aggregate $16 billion, according to Prequin.
“We will see more and more value add deals,” said Martin McDermott, a Los Angeles-based investment broker with Avison Young specializing in value-added office, retail and apartment sales. “In certain constrained markets, there just isn’t much product in the market, and the prices for that property have gone up.”
“Savvy investors who have been around for a couple of cycles are looking at what’s on the market,” McDermott added. “If they feel that all the future value has already been priced into a deal, they would rather buy a property that has a delta between the cost of purchase, carrying and renovation costs, and how much rent they can charge by renovating and putting it back on the market.”
In L.A.’s hot Westside, for example, the rising demand for low-rise collaborative office space from creative-focused entertainment, design and software companies is resulting in opportunities for investors and developers with enough market knowledge to scoop up and reposition older Class B and C office buildings.
No textbook can adequately describe the traits that will make any particular value-added transaction pencil out, McDermott said.
“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,” he said. “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.”
Where to Buy Risk
With office occupancy now recovering at a brisk pace, the second half of the recovery is bringing growth in rental rates, net operating income and property values for investors. Demand is especially acute for suburban office markets such as San Jose, CA and Cambridge, MA, the traditional domiciles for fast-growing tech and life science companies, CoStar data shows.
Even as prices in CBD office markets have accelerated in some cases to bubble era levels, the growth of downtown focused tenants such as government, law firms and financial services hasn’t kept pace. Value-added funds have patiently stocked up on capital for this portion of the recovery.
Some office submarkets are already white-hot, with sales activity in 2013 surpassing previous historical highs. For example, the Denver CBD, downtown Nashville, Boston’s Burlington/Woburn submarket, and several areas in Houston have all had more than 15% of their office inventory trade over the last year — more than three times the national office inventory turnover rate in 2013, according to an analysis by Property & Portfolio Research, a CoStar company.
As capital chased demand into secondary locations in good markets last year, the vacancy rates in downtown Denver, Boston’s Burlington/Woburn, and Houston’s Westchase submarkets fell to below 10%. While most of the trades were for well-occupied properties, a notable minority had significant vacancy issues as value plays – but with rents rising, it makes sense take leasing risk in these locations, according to the PPR analysis.
An example of a classic value-added transaction in a growing metro with plenty of leasing upside was the sale early this year of the Panorama Corporate Center in Englewood, CO, comprised of seven office buildings totaling 821,242 square feet for $145.3 million, or $174 per square foot.
A joint venture of Equity Office and institutional investors advised by J.P. Morgan Asset Management sold the properties to Miller Global Properties, LLC in a transaction that closed Jan. 6. The deal for the property located near the Dry Creek light-rail station included two additional development parcels totaling 11.3 acres, zoned for any combination of office, retail, industrial or residential uses.
The industrial and multifamily markets are also seeing a rising tide of repositioning plays. AEW Capital Management recently formed a joint venture with Sealy & Co. in Dallas to acquire industrial assets in the Southwest and Southeast, making an investment out of the gate in a 20-building industrial portfolio in Texas and an industrial property in Atlanta.
