This article is part II of our series to offer you some more context around each strategy – stabilization, value-add, new construction, and master-planned development. We’ll summarize the general business plan for each, discuss the opportunities and risks, and define the investor profile that may be suitable for each strategy. This article focuses on the Stabilization strategy.
How great does it feel to get a reservation at a hot restaurant? It’s exciting to know you’ve got a table someplace that’s practically guaranteed to deliver on food, ambiance, and service. Now, imagine showing up to the restaurant only to find that your table has an uneven leg. You can ask to be reseated, but the restaurant is fully booked. Do you leave? Or, do you wedge a coaster under the table leg and enjoy your meal?
This scenario is very common in commercial real estate. There’s an outstanding property on the market that’s seeing slightly less demand or a small discount in price because there’s something that needs to be done. These properties tend to be good candidates for what’s known as a stabilization strategy, which is just like adding a coaster to stabilize an otherwise perfectly good table.
We locate a highly utilized property that has some issues that need to be addressed for one reason or another. The goal is to increase the property’s cash flow through light property improvements, increasing the quality of the tenants, or improving property management. Then, once the improvements are made and we’ve seen an increase in cash flow, we sell the property when the environment justifies a suitable exit multiple.
Stabilization properties have minimal near-term leasing issues or capital requirements. This makes it a potentially suitable route for investors who are seeking income, with an opportunity for upside growth potential.
4 Things to Consider in Stabilization Strategy for Real Estate Investments
Let’s walk through some of the high-level points in the stabilization business plan.
Locate a Highly Utilized Asset Property
A highly utilized property is generating cash flow from consistent demand drivers. If not for a few issues, the property would be considered a “core” project – that is, one that offers the lowest risk and highest cash flow. Stabilization candidates are often well-built in a great location but need some improvement.
You should look for opportunities to create value with any property in three areas:
Physical refers to addressing the property’s physical characteristics. In the case of stabilization, think more touch-up than a full renovation. For instance, replacing any old incandescent light bulbs with modern LEDs or reupholstering lobby furniture. These are quick and easy fix projects that don’t take a lot of time. In this category, we’re rarely knocking holes in walls.
Structural refers to the organization of the property, also known as the capital stack. It can take a lot of money to acquire and manage commercial real estate, so most commercial properties have multiple partnerships representing funding from many sources. For instance, we could buy out a retiring partner or decide to refinance the mortgage to a more favorable rate. The end goal is to make the building’s capital stack more efficient to generate higher cash flow, potentially.
Operational refers to the property’s financial performance. These properties are already cash-flowing, so an operational stabilization strategy finds ways to increase that existing cash flow. This could be as simple as raising rents to be in line with the rest of the market or streamlining property management headcount to reduce labor costs (or both). It could also be adding mandatory rent escalation clauses to the lease agreement aligned to the general rise in inflation.
Look for Strong Fundamentals
This refers to the property’s tangible and intangible characteristics. Tangible fundamentals include things like the property’s construction quality and the condition of its furniture, fixtures, and equipment (like HVAC units), as well as its physical location and surroundings.
Intangible fundamentals include the market’s trends in:
- Pricing – are they rising or falling?
- Demographics – are they getting younger or growing older?
- Development – are they competitive or idle?
A property is a good stabilization candidate if the intangible fundamentals imply a market with attractive demand drivers (like a major employer in the area) and intangible fundamentals that need modest improvements to improve cash flow.
Once the work is done to identify a good stabilization candidate, the sponsor packages that together and presents the plan for investors to consider. Commonly, the team bundles several stabilization properties into one fund. The fund approach helps diversify your risk in investing versus putting everything into just one property. Since stabilization properties are more for cash flow than upside growth, a fund may include value-add or opportunistic properties as well to provide a balanced risk and return profile
Next, the team lays out the property profiles that may be acquired for the fund, how much total capital is needed, and the potential returns you could enjoy for investing in it.
Stabilization properties are good candidates for a long-term hold – think seven years or longer.
In no small part, that’s due to their historical track record of weathering recessionary conditions better than riskier projects, while generating cash flow throughout the hold period. However, there are conditions where it makes sense to sell a stabilization project.
Selling a Stabilization Project
Institutional investors are big firms managing tens of billions of dollars for their stakeholders, which are often real estate investment trusts or pension funds. They prefer to buy properties that have already been stabilized and are generating consistent cash flows. Commonly, these big firms will pass on an otherwise perfectly good property because it needs some work.
Institutional investors have historically had an appetite for a diversified or aggreged portfolio of stabilized assets, often purchasing them at a premium.
What are the Risks of Stabilization Strategy?
Stabilization properties are highly attractive to institutional investors because they tend to be fairly recession-proof cash flow machines. For instance: if you own a medical office with a specialty like renal care or cancer treatment, demand shouldn’t slack off even if the economy is in a recession. People who need dialysis or chemotherapy will continue to make appointments.
Another example: the housing market can boom and bust, but apartments are very steady. You can sell your home and live in an apartment or downsize from one apartment to something smaller, but the next step after the apartment is a shelter. Most people will pay their rent.
The risk to a stabilization strategy is often structural. These properties are already cash flowing, so there’s scant opportunity to boost the exit multiple like you’d see in a value-add deal.
It also helps to invest with a partner who has a track record of producing value across the real estate risk spectrum and has managed investor capital through a recession. Click to listen to Caliber’s CEO Chris Loeffler discuss how Caliber managed the business through the pandemic-induced recession.
Who is a stabilization strategy right for?
Stabilization is a good fit for an investor seeking income and willing to take a modest amount of risk.
When done correctly, stabilization strategies should be straightforward. You acquire a great property, make a few improvements to boost cash flow, then sell (ideally to an institutional investor) when the market justifies the exit multiple.
Caliber’s story is rooted in a set of investment principles that are now the company’s foundation. These principles were created naturally during our first formal year of operations, raising $18 million from investor-partners and buying, renovating, and selling over 150 single-family homes in 2009.
Click here to see Caliber’s current property portfolio.
Caliber Companies is a private equity real estate company that focuses on sourcing compelling real estate opportunities in key Southwestern states for individual and institutional investors. The firm’s founders have decades of experience executing high conviction real estate strategies that generate attractive risk-adjusted returns. The firm deploys a vertically integrated business model that includes acquisitions, development, construction, asset management, and disposition.
Contact us at [email protected].