is there room for value-add investing in an "era of less"?

In a video introducing the Urban Land Institute’s recently published report, Emerging Trends in Real Estate 2011, Mitchell Roschelle of PriceWaterhouseCoopers stated that real estate “will be a smaller industry...less transactions…less people needed…less financing needed. [The industry will be] smaller and more compact” in the future.

So, in an environment recently characterized by the ULI as “an era of less”, where double digit returns are the exception, debt and equity are more difficult to obtain, and fast rising demand is less assured, what should we do? How should expectations, investment strategies and operations change to respond to a brave new world of commercial real estate?

Institutional investors have already made clear that their strategy is to invest in fully stabilized assets in the top-tier markets – driving capitalization (“cap”) rates on many acquisitions this year below 6% or even 5%. According to Real Capital Analytics, in the second quarter of 2010, average multi-family cap rates were in the range of 6.5% and office had dropped to less than 8%. Examples of 5% cap rates or less keep cropping up as intense bidding wars break out over select properties. Most of these sales, however, are at the safest end of real estate, for assets in top-tier gateway markets, with stabilized occupancy and a clear view to future leasing. Markets like Washington, DC and New York have office cap rates in the sixes, while secondary markets might see rates in the 9% range. Steve Quazzo, CEO of Transwestern Investment Company pointed out during the 3^rd quarter roundtable, “The overriding theme these days among institutional investors, pension funds and insurance companies is ‘Back to Basics’.” Perhaps appropriately for institutions safeguarding the retirements of millions of workers, their response to the new market is a wise yet defensive course. No fortunes are made, but the risk of loss is much lower.

But what about “value-add” strategies? Throughout history, not just in the last economic cycle, the more interesting returns come from making something happen, not just clipping coupons. Does this new “era of less” still allow for “value-add”?

Yes it does, but there has to be real value added.

According to Jason Choulochas, Managing Director, Investments at Wrightwood Capital, “In the last cycle, the words started to lose some of their meaning. Everyone seemed to claim a ‘value-add’ strategy, but a good number actually achieved their returns, not through the execution of their business plan, but through cap rate compression combined with low priced high leverage debt.” Bob Dennis, a debt fund manager at Wrightwood Capital, added, “There were a lot of ‘value added’ players who were actually traders. This downturn has sifted out the traders from those who know how to make things happen at the property level.”

Jason continued, “There was almost an automatic ‘do the rehab and they will come’ attitude. Even if the first investor didn’t complete the business plan, they could sell the dream to the next value-add investor and still meet their return thresholds. Demand kept coming, money was cheap, lease rates were elastic and location was less of an issue than ever before.”

Not anymore.

As Jason pointed out, “The entire culture has changed to the point where people are less likely to stretch in order to chase a dream. Everyone wants to live within their means. In multi-family, renters are less willing to pay another $200 per month for granite countertops and stainless steel appliances. In office, tenants are less likely to reach for new amenities or specialized tenant improvements. Retailers are becoming very selective about where they locate and how much they are willing to take on.”

Wrightwood Capital has funded several value-add transactions this year, and is continuing to do so. By no means is it an easy task to underwrite pro-formas in this environment, but it can be done. For example, this year Wrightwood Capital closed on a $23 million preferred equity investment in the $275 million recapitalization of Franklin Lakes at Greenbelt Station in Greenbelt, Maryland. They also provided financing for a couple of borrowers to repurchase their debt at a discount, including an $8,600,000 first mortgage for Crossroads Lakes Business Park in Bolingbrook, Illinois, and two debt acquisitions, including a $4,150,000 first mortgage to CapRock Partners for two industrial buildings in Chino, California. They are also working on a new student housing development and have closed a couple of ground up construction deals this year, including two loans totaling $6.7 million for a Walgreens development project in Wheaton, Illinois.

Based on the experience of deals this year, there are a few things to keep in mind when value-add investing in this new environment:

1. Buy at the right price. Given the rampant uncertainty of both costs and values over the next few years, you need the gap between your expected return on cost and exit cap rate to be as wide as possible. Most of the attention in today’s market is appropriately focused on safer institutional deals where cash flow is already in place, but select value-add opportunities are starting to come down to a workable price. Be very mindful about your basis, you need all the room you can get.
   
2. Location, location, location. We may have lost track of this fundamental golden rule of real estate during the last cycle. Maybe in the past it was possible to make easy money on new exurb retail or suburban office parks surrounded by nothing but parking lots– but with “Baby Boomers” and “Echo Boomers” alike moving closer to urban centers for convenience, lifestyle and efficiency, driving less and demanding more amenities close at hand, the location of an asset is more important than it has been in years, (consider the report by Kiplinger, Generation Y Giving Cars a Pass, September 14, 2010, which revealed that motorists aged 21 to 30 now account for 14% of miles driven, down from 21% in 1995).

   
   As Frank Sullivan, Senior Regional Director at Wrightwood Capital puts it, “If you are waiting for a rebound in commoditized suburban office, you may have to wait a very long time.”
   

3. Have a solid, well thought-out and measured business plan. In this environment, precision is everything. According to Jason, “In the past, you could put in something like $25,000 per rehabbed unit in multi-family and still make a 15% return on the incremental dollars. Now you have to make that same return with only $5,000.” It is near impossible to achieve return goals unless you are able to make very strategic and very careful investments of incremental dollars.
   
4. There has to be a high degree of certainty that you will complete the business plan successfully. Not only does the plan have to be solid with little left to chance, but the ability of the investor to execute the business plan successfully has to be certain. With a smaller margin for error, experience is crucial.

Bruce Cohen, CEO of Wrightwood Capital recently pointed out, “Value-add investing is not only possible in the current environment, it makes good sense if you are willing to do the basic blocking and tackling of real estate that we may have let slip a bit in the last cycle. Forget about getting rich on the promotes, instead focus on building good relationships and building new value in assets. There is a lot more skepticism now – and that is only appropriate. For now, value-add is all about “trust, but verify”. Investing may still require trusting the sponsors’ ability to execute a business plan – but we all have to make sure we verify that it will work as planned. Easy leverage and fast climbing values aren’t there to save us when we’re wrong.”

(This is a reprint of an article printed in the Credit [r.e.]View)