Investors do not always agree on how they define “value-add” investment. But one thing they can agree on these days is that they want more of it.
Investors are showing increasing preference for allocations to value-add assets compared to core and opportunistic investments, according to the 2015 Pension Real Estate Association (PREA) Investment Intentions Survey. Overall, 77 percent of investors who responded to the survey said they expect to buy value-add investments in the U.S. this year, compared to half who plan to buy more core assets and 28 percent who expect to invest in opportunistic properties.
“According to our numbers, definitely over the last year you have seen a move away from core and towards the value-add sector,” says Greg MacKinnon, PhD, director of research for PREA. Last year, the sentiments for plans to invest in value-add and core assets were comparable, with only slightly more investors favoring value-add at 62 percent, and 60 percent of investors who said they expected to make core investments in the U.S. in 2014.
The growing interest in value-add is being fueled by a combination of factors. The most notable reason is falling yields for core properties. Just like in 2014, there is a lot of capital in the market, both domestic and foreign, that is buying commercial real estate.
“We expect cap rates to decline in most property types and most qualities, just due to investment activity,” says Jeanette Rice, Americas head of investment research at CBRE Research and Consulting. So investors that stick with core will have to reduce yield expectations.
“Core capital has started to flow to the best quality assets in secondary markets to find a home for its growing base of capital and achieve incrementally better return as compared to the traditionally core markets,” says Justin Hildebrandt, executive director, real estate investments, at USAA Real Estate Company. USAA Real Estate Company completed approximately $1 billion in transactions in 2014 and the firm expects that volume to increase in 2015.
According to Hildebrandt, USAA Real Estate Company has changed some of its strategies or shifted into other parts of the capital stack that still provide attractive returns, but also feature more downside protection. “In addition, we have found interesting value-add and development opportunities where we are able to have an attractive basis as compared to many of the core trades, but we are also comfortable with the risks of construction and lease-up,” he says.
The recovery in the U.S. economy over the past year is giving investors more confidence in taking on risk related to value-add properties. In addition, value-add properties are more appealing given expectations that interest rates may rise. If interest rates do tick higher, it will likely be because the economy is recovering. “So the way to protect yourself from a rise in interest rates is to have some kind of growth potential in your assets,” says MacKinnon. Value-add assets provide for that growth with more opportunities to improve occupancies and raise rents.
Moving from core to value-add is a step further out on the risk spectrum. “But in general, people aren’t jumping into the deep end with both feet,” says MacKinnon. To that point, there has not been a big increase in investors looking to do opportunistic investment. Another interesting note is that that the increasing allocation to value-add is occurring largely among domestic investors. Foreign investors coming into the U.S. remain much more focused on buying core assets in the top six metros, he adds.
So what are some of the hot value-add buys in today’s market? “I think what you will find is that the markets that have the dearest pricing right now for core is where people have most interest in value-add,” says MacKinnon. Typically, that means investing in value-add projects in suburbs around the major metros, as well as some of the dominant secondary markets. For example, investors are looking at value-add office buildings in markets such as New York, Boston and Los Angeles.
The question in every property sector is “What is the next segment that offers more value?” adds Rice “We see the suburban office market as having a lot more value than what had previously been perceived,” she says. So far, capital hasn’t really migrated to suburban offices to a great extent, but that will change in 2015, because central business districts (CBDs) and urban office areas like Atlanta’s Buckhead have seen prices driven up, says Rice.
In the multifamily sector, what has been really hot is urban infill and hi-rise apartments.
“But there is not as much upside in the urban product as we see in the suburban product right now,” says Rice. There has not been as much multifamily building in the suburbs, and there is still plenty of demand for that product. “So that is another area where we believe we will see a little more migration on investment,” she says.
An article written by Beth Mattson-Teig
Jim Gramata is an experience real estate investor with a wide range of skills and achievements ranging from his design/build experience and flipping properties to real estate sales and marketing. He is a licensed broker with @properties in Illinois.