For the past several years, investors have turned to the value-add strategy when seeking outperformance in a competitive commercial real estate landscape.
And it appears the interest in these type of deals has only intensified lately, with competition becoming increasingly stiff as the industry faces the likely end of the cycle and rent growths have moderated for core assets.
“When you have capital appreciation that starts to moderate, then investors seek outperformance,” says Brian McAuliffe, president of institutional properties at real estate services firm CBRE. “And when they seek outperformance, they have to take added risk and that’s where the value-add opportunities become greater in demand going forward.”
As yields get lower and lower, traditional buyers of core assets are more and more looking elsewhere. Now, two strategies have emerged among this group: speculative building and value-add, says Rene Circ, a director with CoStar Group, a commercial real estate research firm. “Value-add has become quite attractive in market environments like this,” he says. “People are less afraid to take on vacancy risk and reposition buildings.”
There may be no shortage of investor demand for value-add assets, but moderation in rent growth and more intense competition can make them harder to pin down. There has also been an even greater influx of capital from high-net-worth investors, who have turned to value-add assets amid the growing concern over the pricing of core properties, McAuliffe says.
“Those transactions are much more difficult to achieve because rent growth has moderated, so you’re not getting the bump in rent growth after you create those value-add opportunities. That ends up being a pricing discussion in the marketplace,” he notes.
In the multifamily sector, which continues to see strong demand overall, the strategy has been pervasive for about three to four years, says Jeff Daniels, national director of Institutional Advisor’s (IPA) multifamily division. And these assets are still in high demand. When IPA markets a property, Daniels says the firm receives 15 to 20 bona fide offers. “Finding assets that fit that strategy is extremely competitive,” he says.
Sellers also know that investors seeking these deals are extremely bullish, so they are using the aggressive capital to trade up quality, Daniels says.
The increased competition has led to some creative solutions.
Jon Morgan, co-founder and managing principal at Interra Realty, in Chicago, says the push to find more edge, particularly in the multifamily sector, has caused investors to look beyond acquiring older apartment complexes in need of renovation.
For example, his firm recently sold a funeral home with an adjacent parking lot to an investor who is seeking to convert the funeral home into a mixed-use property, with apartments on top and retail underneath. The buyer’s lender required a phase I environmental assessment, but to Morgan’s knowledge, the property did not need to complete a remediation before closing.
The lot, Morgan says, will become a new apartment building. “People are trying to go outside of the norm,” he says.