For investors striving to grow and preserve their wealth over multiple generations, opportunistic and value add real estate strategies can play an important role in diversified portfolios. Let’s take a closer look at the key features of these non-core real estate strategies.
What is Value-Add Real Estate Investing?
When pursuing a value add approach, sponsors aim to generate returns by proactively enhancing the value of a commercial real estate asset and increasing its cash flow during the holding period. Sponsors can apply a value add strategy to a variety of property types—that said, it’s particularly popular with multifamily assets.
When looking to make a value add investment, many sponsors seek out locations with strong rental growth rates, then identify assets that haven’t, for whatever reason, kept up with the recent growth, creating an opportunity for the sponsor to make improvements.
In short, the plan is to buy the asset and fix it up. This enables the sponsor to collect higher rents, thereby boosting the asset value and paving the way to a compelling return. It’s all about seeing the potential—then maximizing it.
Techniques to add value include:
- Physical improvements and renovations – Sponsors can reconfigure spaces, modernize interiors, resolve deferred maintenance, upgrade common areas, and refresh landscaping. Changes can range from minor improvements to major repositioning.
- Optimize operational expenses – Sponsors can increase net operating income by completing proactive maintenance, installing energy efficient technology, and re-pricing contracts for marketing and maintenance.
- Improve asset management – Better management practices can help sponsors implement lease-up strategies, increase revenue, set optimal pricing, and forecast opportunities.
Opportunities for value add investing can come and go depending on the state of the real estate market. The period following the 2008 global financial crisis is a great example of ideal market conditions for value add strategies. When real estate values fell below the cost of construction, building and selling new properties—as pursued in opportunistic strategies—didn’t make any sense. Value add strategies were a better choice. Investors bought tired buildings that needed work, improved the buildings, then benefited from the higher cash flow.
Think of a 200-unit apartment complex built in the 1980s and in need of renovation. As tenants move out, you complete the renovations on a unit-by-unit basis, transforming each apartment’s flooring, finishes, and appliances. You’ll then be able to rent the renovated unit for a higher rate—or maybe even to an entirely different class of tenants.
It will take time to cycle through each unit, usually multiple years. During this renovation period, net cash flows may decline to zero—but investors who are willing to wait for the value add strategy to come to fruition and eventually produce distributions will typically receive a higher rate of return than core and core plus investments. Value add investors aim to generate the same net profit as a core or core plus buyer, but their cost basis is lower, which increases the rate of return. A lower cost basis also gives value add investors greater flexibility when selling or absorbing rent declines during a recession.
Potential Benefits and Risks of Value Add Real Estate Strategies
For many investors, the key benefit of a value add strategy is the opportunity to earn a greater return than in a core real estate strategy. By proactively working to increase the net income generated by a given property, value add sponsors are positioned to deliver greater returns than those available in a core strategy based on stabilized, in-place income and gradual capital appreciation.
While fixing up a property can potentially boost its value, it also creates risk. The risks of value add investing are fairly clear and largely related to execution. For example, you think you can improve the management and net operations of a property—but once you get started, you may find you misunderstood something about the property, you can’t improve the profit, and there is no upside in the value add strategy. On the construction side, perhaps your actual cost to renovate units is above expectations, or you didn’t fully understand the market and aren’t able to raise rents to your target level after renovations.
What is Opportunistic Real Estate Investing?
Opportunistic investing is a lot like investing in small, early-stage companies where the management team is working hard to grow something of value. By coming in at an early stage, investors take on more risk and are positioned to benefit from more upside.
There are three main categories of opportunistic investing:
- Ground-up construction – Starting with a piece of land and building something new
- Adaptive reuse – Changing how a property is used, for example, taking an office and turning it into an apartment complex
- Heavy renovation – Taking the property all the way down to the studs
In opportunistic strategies, investors rely heavily on their sponsors to execute well. Sponsors and fund managers are tasked with creating value at multiple stages, including purchase, construction/renovation, and leasing. The timeline is also important to understand. It can take multiple years to buy land, navigate the necessary approvals, complete construction, then finally begin leasing the property. Investors should expect no cash flow in the first three to four years, maybe longer.
Potential Benefits and Risks of Opportunistic Real Estate Strategies
The advantage of opportunistic investing is its low cost basis, and therefore a higher rate of return. Opportunistic investments typically have a five-year horizon or longer. In a five-year underwriting, managers generally look to double the value of the equity investment, i.e., 2x equity multiple. The target internal rate of return (IRR) on the investment is typically above 15%.
Risks in opportunistic strategies depend on what’s being done. With heavy renovations, investors face risks that upgrades will cost more than expected and rents can’t be sufficiently raised post-renovation. With adaptive reuse, risks surround the required approval processes as well as execution risk around the renovation. With ground-up development, risks are associated with the acquisition process, land rights, and construction timeline.
How can risk be reduced in opportunistic investments? One option is to reduce leverage. With less debt, managers can make some mistakes or incur delays yet still produce a compelling return. Managers can also look to reduce specific risks, for example, by securing a fixed-price contract for construction to reduce the risk of overrun, or signing on high-quality tenants before construction is complete.
3 Things to Consider Before Investing
Before committing to a value add or opportunistic real estate investment, investors and advisors should examine the following:
- What role does real estate play in the investor’s portfolio? You’ll need to complete a thorough review of the existing portfolio across all asset classes, considering investment time horizon, investment goals, liquidity needs, and risk tolerance. From here, you can establish a framework for allocations to real estate product types, asset types, and strategies.
- Within the category, which investments are the best fit? The value add and opportunistic categories span a range of investments, with some carrying more risk and potential return than others. Each investor must decide whether an investment’s potential return is appealing within the context of its risks. Some characteristics to analyze include:
- Market fundamentals – What is the outlook for the location and asset type? For example, a property in a lackluster suburban location that’s exposed to cyclical fluctuations carries more risk than an asset supported by long-term demand drivers in a location with sustainable job growth.
- Project scope – What is the sponsor’s business plan? For example, a project that aims to complete cosmetic upgrades to 25% of the units in a slightly outdated apartment complex is potentially less risky than one targeting major electrical and plumbing changes in every unit of an aged building.
- What is the sponsor’s experience? Track record, organizational structure, and experience are especially critical for success in the value add and opportunistic arenas, given the hands-on role played by sponsors.
Caliber’s Advisor Resource Hub
To learn more about value add and opportunistic real estate investments, visit our Advisor Resource Hub or contact our team today.
About Caliber (CaliberCos Inc.) (NASDAQ: CWD)
With more than $2.9 billion of managed assets, including estimated costs to complete assets under development, Caliber’s 16-year track record of managing and developing real estate is built on a singular goal: make money in all market conditions. Our growth is fueled by our performance and our competitive advantage: we invest in projects, strategies, and geographies that global real estate institutions do not. Integral to our competitive advantage is our in-house shared services group, which offers Caliber greater control over our real estate and visibility to future investment opportunities. There are multiple ways to participate in Caliber’s success: invest in Nasdaq-listed CaliberCos Inc. and/or invest directly in our Private Funds.
Investor Considerations
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
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