The Case for Value-Add Investing in 2011

(This is a reprint from Wrightwood Capital's regular column, The Credit [r.e.]View)

Everyone’s closing the books on 2010, a year that perhaps can best be described as “not as bad as 2009”. According to Real Capital Analytics, there was over $132 billion of property sales – double the volume in 2009, but only 23% of the deal activity in 2007. It should be noted that almost half of 2010’s volume ($52 billion) was closed in the fourth quarter – indicating an increase in activity and perhaps significant momentum for the first quarter of this year. If that momentum is real, we can all look forward to a more interesting 2011. According to Jason Choulochas, Managing Director of Investments at Wrightwood Capital, “By historical standards, we’re still at numbers that are a fraction of where we were before the recession, but the trend line is going in the right direction – and is starting to increase at a non-linear, perhaps even exponential rate.”

If the pace of investing is increasing, an important question to consider, is what kind of investing will we see? Last year, the majority of the $132 billion transacted only at the upper end. The investment strategy was quite clear: invest in fully stabilized assets in top-tier and gateway markets. The only game in town seemed to be core assets – and with capital chasing a limited pool of those assets, the laws of supply and demand quickly went into effect. Despite a year of anemic 9% plus unemployment, falling rents and record foreclosures, average capitalization rates for multifamily hovered in the mid 6% range, while the best assets saw sub 6% or even 5% rates. Prime office was also very popular, dropping precipitously from 2009 pricing into the 7% range by the end of the year. Despite a frustratingly slow recovery and stubbornly poor real estate fundamentals, there were actual bidding wars. It almost seemed like a return to better days, but those heady feelings were limited to very small group of assets at the top. At the same time, very little value-add transactions were completed – and if they were, their capitalization rates were much higher.

Will there be an increase of value add activity in 2011? That may depend on the mood of institutional investors. In 2010, the appetite for anything less than core was limited at best. During Wrightwood Capital’s 4^th Quarter Credit Roundtable, Derek Tyus of Northwestern Mutual summed up the 2010 institutional investor’s mindset quite well. He said, “What some might call value-add in 2010, we generally characterized as opportunistic – even speculative – and we just don’t have the appetite for that. But we are losing out on a lot of transactions because the pricing is unbelievably aggressive right now.”

If there’s now less room at the top, could this bode well for those in the middle? According to Joe Pagliari of the University of Chicago speaking at the same roundtable, “Yields from safe assets are now so low that investors could get tired or even scared of near 0% returns. Defined benefit plans, for example, must earn something around 7% or 8%. They can’t get there without accepting more risk.”

But are they ready to take on more market risk? Will they invest in assets that aren’t completely stabilized and have some leasing, repositioning, or improvement left to accomplish? According to Dan Hartman, Senior Regional Director of Investments for Wrightwood Capital in the Northeast, “They might want to consider value-add again, or at least core-plus. The pricing on stabilized assets has become so competitive, that there is very little room for error. Even if your return expectations are very low, the lack of meaningful potential upside could make you more susceptible to loss of yield in the event of downside. A tenant vacates, a change in taxes, interest rate increase, cap rate increase or a continued slow capital markets environment when you sell could easily cause a meaningful decrease of an investor’s real returns. And if the investment has little room for upside, it could be hard to recover from a downside event. Certain value-add investments could even be seen as more prudent – in that they have room to improve.”

Bruce Cohen, CEO of Wrightwood Capital, agrees, “Investors in the current environment are paying a potentially excessive premium and correspondingly are accepting very low yields for stable cash flows that are not likely to improve much. In a rising rate environment, they may find themselves with sub-par returns. On the opportunistic side, some are taking incredible event risk or betting against capital flows, which may also turn out to disappoint if things don’t transpire as planned. Ironically, in this market, it is likely to be the value-added projects, with current yield but a sound business plan to grow income that will most likely outperform.”

Frank Sullivan, Senior Regional Director, Fund Management for Wrightwood Capital in the Southeast and Texas pointed out that he had been involved in a couple of interesting value-add transactions in the last two quarters that are positioned well for healthy returns in the next few years, even if the recovery continues to be slow. “You have to be selective and somewhat careful. By no means is it an easy task to underwrite pro-formas in an uncertain environment, but it can be done. I believe this is the point in the cycle for smart investors to work in value-add.”

Mark Macedo, Senior Regional Director of Investments for Wrightwood Capital on the West coast agrees, “Distressed sales accelerated considerably last year, with half of them taking place in the last quarter. That pace is likely to pick up even further this year as banks are likely ready to clean up their portfolios. They won’t be selling off the top performing assets – but there will be opportunities for capital that is willing to invest in a smart business plan on those assets.”

Dan, Frank and Mark speak from some experience in 2010. As the market started to thaw, Wrightwood Capital provided debt for a few non-core transactions, including 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 also 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.

“It probably won’t be easy,” pointed out Jason Choulochas, “the best of historical returns are unlikely to fall into anyone’s lap any time soon. But 2011 is likely to be a year where value-add is a must-have element of any prudent real estate investment strategy and this year’s vintage of investments has a good chance to make up some of the losses we all experienced in the last few years.”