Value-Add Investments in the Real Estate Industry
Value-Add Overview
You may have heard the term “value-add investment” before when referring to real estate, but what exactly is this concept? How does it work? What are some of the tools you need to be successful?
Value-add investments are an innovative process that combines the different elements of arts and science. In simple terms, value-add investments are properties that require improvements in order to increase its overall value. These plans typically target properties that have in-place cash flow, but over time seek to increase that cash flow by making improvements to reposition the property, thereby increasing revenues or reducing operating expenses. In order to maximize this opportunity, a plan to raise rents or reduce expenses must be in play to make up for capital investment in the property itself.
There are many properties that are in distressed or rundown conditions because many owners don’t have enough capital to make these improvements or have reached a point of obsolescence to where they don’t care to improve the quality of their properties. Much of the success behind value-add investing requires a vision along with creativity in order to truly uncover and understand the potential an asset could contain. The investor must also have a strong plan and discipline to successfully carry out their investment goals which maximizes results. Although this “value-add” concept has been around for a very long time, value-add investments have been dominating the multifamily markets as it is clear that there is a huge trend reflecting the idea that residents are willing to pay higher rents in order to improve their personal living experiences.
Many times, the capital improvement made to the property is of a size and amount that the owners would choose to capitalize the improvement from an accounting standpoint. However, it is not uncommon for the owner to actually expense the improvement in an effort to secure the tax write off in the current period. In the event the property owner elects to expense the improvements, they will generally see a reduction in net operating income for the short-run, yet will see a material increase once the improvement are completed. The following is a visual example of such an expense treatment:
These charts are supposed to show how NOI may expectedly drop, but then recovers into a state of stability and smooth growth. This leads us to believe that this goes hand in hand with the unit renovation schedule.
Value-Add Categories of Opportunity
While there is a plethora of opportunities that “add value” to multifamily properties, each strategy being dependent on the market or property, they are usually focused in one of three different categories: operational enhancements, capital improvements and total repositioning.
The first category, operational enhancements, are usually the most common in under-managed properties. Oftentimes, they also require little or nominal capital investment. Enhancements to property management can drive some of the quickest improvements in net operating income. Some examples of operational enhancements include reducing expenses, raising rents to meet market level, and enforcing fee income policies, such as pet fees or late fees.
Capital improvements can be extremely crucial as they increase the attractiveness image, curb-appeal and overall desirability of the property. Although this potential revenue source can take place in many shapes or forms, the most impactful and measurable are properties that undergo interior improvements. An example of a capital improvement can be kitchen or bathroom upgrades that can increase the appeal … and rental rates … of an older or vintage apartment property.
The final category is total repositioning. This strategy evolves around the idea of transforming a community’s marketability to appeal to more affluent residents. This category is especially unique as it combines aspects of the other two categories, operational enhancements and capital improvements. To give an example of total repositioning, you can utilize the expiration of a Land Use Restriction Agreements (LURA). When a LURA related to an affordable housing property expires, rent restrictions usually fade away or altogether are eliminated, thereby allowing the property owner to increase the rents to standard market levels. This can trigger resident turnover, which ultimately leads to higher-income clientele, elevated property valuations and overall enhanced identity of the property.
Finding Success in Value-Add Properties
When looking to be successful with a value-add investment, it is important to choose renovation opportunities that potentially have the most embedded upside profit potential. Properties that are viewed as older, uglier, in disrepair, mismanaged and generally unsightly have the potential to be more profitable. In other words, you have a greater incremental increase in value when taking a D- property to a C, that a C to a C+ property.
It is important to find a property that may not be the most aesthetically pleasing, but has no structural issues. Then, you must rehab it and reposition it within the micro-location and market in which it serves. If the specific property is substantially more unattractive than other properties in the market, and there is significant room to raise the rents once the property is renovated, then that is worth investigating further. In simple terms, this strategy can best be defined as “ugly with good bones.”
Instead of taking the rent roll of the entire property and forecasting how much each individual unit will require in terms of renovations to predict the available rent premium, there is a smarter and more efficient way to execute this process. The whole idea is that a property owner has a bunch of apartment units that produce an aggregate cash flow. Based on this approach, this bundle of units can be viewed on a hypothetical average basis, that commands a certain average rent. Because all the units in an apartment start from a similar level and end up at the same state, it makes more sense to utilize an average renovation budget per unit, along with an average monthly rent premium, when determining the cost-benefit analysis.
Predicting Future Disruptive Trends in Real Estate
Embrace the Change and Become an Early Adopter
Abraham Lincoln once said, “The best way to predict the future is to create it.” And there is no industry where that is truer than in the real estate industry. After all, you can control the location, the asset class, the architect, the general contractor, the target market, the capital decisions, the tenant mix. You control everything … right? Or do you?
When one thinks of a “disruption” in an industry, they generally think of a new technology or a new “start-up” as the disrupter. Therefore, something as mature and stable of an industry as real estate, one would think, should be immune from shockwaves caused by these disruptions and “new ideas.” However, in the current and uncertain times in which we live, nothing could be further from the truth.
Predicting the future, when it comes to real estate, is essential to success in the field. Although there is no crystal ball when it comes to real estate, it is important to sit back, analyze, and think outside the box when it comes to a list of predictions of the major things that the industry should focus on in the coming years. These items range from impacts caused by demographic, psychographic, pandemic, economics, geopolitical and many other trends and impacts caused by the “new normal.”
The Corona Effect
Yes, we have to talk about it… As we have all learned this year, life can be very unpredictable. Normal life has been flipped on its head and has tested everyone. One of the effects on real estate has been the movement out of office space, ostensibly for social distancing purposes, but what does this mean for the future of office buildings … and their tenants. Yes, technology has advanced to enable everyone to be connected, whether they are sitting at their desk in an office or sitting at their kitchen table. Plus, many folks are seeing the benefits and efficiency of zero commute time, a more efficient workforce, lower facility cost, etc.
While right now it seems like a short-term reaction to the pandemic, this is a trend that will, most likely, not die soon. Many major companies have already started to permanently get rid of their office space and move to remote working arrangements. British Petroleum, for example, is in the process of permanently shifting almost 50,000 employees towards remote working and flexible workplace layouts over the next 24-months. So, it seems like office space is getting ready for a shock as existing tenant leases come up for renewal. The prognosis is that office vacancies will grow, and rental rates will be stagnant or decline.
As for retail, the International Council of Shopping Centers (ICSC) has historically cautioned retailers that digital technology will have an affect on the brick and mortar sales, but, what the ICSC did not see coming, was the large amount of tenant defaults, bankruptcies and downsizings that were as a result of the government-mandated closure of many retailers. So, what this means is that many retailers that once never thought a certain center or location was in their price range, now have the ability to negotiate from a position of strength with these desperate landlords that are now looking to fill vacated space. The prognosis is that retail vacancies will grow, and rental rates will be stagnant.
But not to fear, there is still need for other forms of traditional real estate, in particular commercial and multifamily real estate. There will still be some demand for office flex space, along with increased demand for industrial spaces as constraints are put on the supply chain. Furthermore, there will be increased demand for assets such as fulfillment centers, cold storage and dry storage for online ordering, and additional factories as popularity of onshoring sweeps the nation. The prognosis is that demand for the industrial, storage and fulfillment facilities will grow, and rental rates will escalate.
With respect to multifamily, the current economic forces have had an impact on the incomes, livelihood, and savings of many citizens. As a result of this, and in particular for middle class America, it appears that many of these folks will continue to stay in a rental pool for the foreseeable future. The prognosis is that the demand for multifamily will remain high, and due to the effects of Covid-19, rental rates will remain flat, until clarity is reached for future employment outlooks.
A note about Covid-19 when it comes to the residential sector is that people have learned that their home (whether multifamily or single family) matters … a lot. Months on end stuck in the house has led people to question their current living conditions. And to go along with the shift away from offices, private designated workspaces in homes or apartments will be more important. People will be spending more time at home and as a result, spending more time inside the home. For these reasons, people are now be looking for larger residential units with private office space and as much yard as they can get.
Another underlying impact of Covid-19 is that people have also learned to appreciate public outdoor spaces a lot more. Parks and other outdoor areas have become a very important commodity. Access to outdoor amenities will feature more prominently in the future of real estate, whether we are talking about private communities, commercial spaces, or urban planning. While Covid-19 is temporary, its effect on the world, and impact on real estate, will be felt for decades to come.
Emerging Markets
International urbanization is the name of the game. Cities have been, and will continue to be, welling across the fast-growing countries in Asia, Africa, Middle East, and Latin America. Along with that, developed western nations will continue to urbanize. By 2050, urban populations are projected to increase by 75% to 6.4 billion, from 3.6 billion back in 2010. China will be leading the way by moving 70% of their population, about 900 million people, into cities by 2025. Asia will be the fasted growing region, with sub-Saharan Africa right behind.
Populations are rising and the United Nations has stated that by 2050 the world population will be 9.8 billion, up from 7.8 billion in 2020. The need for living space will be highly in demand for both the emerging markets we have already looked at, but also already established markets in the west such as cities like London, who’s population is forecasted to rise to 10 million by 2023, from 8.9 million today. Along with the growth in population, the middle class will rise by about 180% from 2010 to 2040. Global construction output is expected to almost double to $15 trillion USD by 2025. Also, by 2025, emerging markets will host 60% of global construction activity. China, United States, Indonesia, Russia, Canada, and Mexico will account for 72% of expected construction activity.
Public Private Partnership
The economic implications of Covid-19, and the ability for cities to maintain consistent sales and property taxes, will ultimately have an impact on the revenues and capital budgets of municipalities. Consequently, these municipalities will be searching for additional ways to advance economic development efforts and encourage development in their respective cities. Going into this new age of real estate development, working in partnerships with government bodies, will be very important. Not only will the investment community need in-depth knowledge of local economies, but also, they will need to navigate opaque planning laws, access to governmental incentives and to work in partnership with the government and to make sure their strategy is aligned with the private sector. Governments are going to want construction and economic development in their cities and will be looking to collaborate with private developers.
Co-Living
The advent of the “sharing economy” has made an impact on several industries ranging from Ridesharing, to co-working to vacation rentals. But what about a “co-living” trend? While it might seem like something like a commune or a kibbutz, co-living has become one of millennials favorite ways to live. The idea of co-living is to create a cost-effective environment for likeminded people to live and work.
People rent individual rooms, but share common areas such as a kitchen, living room, recreation area and outdoor space. This allows for the individuals rental cost to be lower as common areas are a shared expense, and the stress of setting up a new home is eliminated. Another desirable aspect of the “co-living” space is the social opportunity of meeting and living with others with similar interests. For whatever reason they choose, co-living is a growing lifestyle for the younger generation. While it has started to take off in the United States, other areas such as Asia and China have already fully embraced the idea.
A great example of an early-adopter is Ziroom. Ziroom is a co-living style apartment building that has properties in nine of China’s major cities that total over 1 million bedrooms. Ziroom already has over 1.2 million residents that have embrace the concept. The rooms that they offer range from around 100 to 300 square feet and come with the many shared spaces including coffee shops, bars, gyms, libraries and relaxing spaces such as rooftop greenspaces. Ziroom has already seen much success and has made the idea of co-living “cool and desirable.” The trend of co-living seems like it will continue to spread through Asia, while it becomes a mainstay in living in the west.
Technology in Real Estate
Blockchain is here and it is not going away. If you are not yet familiar with blockchain, here is a short explanation: at its most basic level, blockchain is literally just a chain of blocks. Blocks store information about transactions like the date, time, and dollar amount of transactions. In simple terms, it is a way to store transaction information in a decentralized data base. Real estate transactions are, for the most part, conducted in offline engagements and transactions. Blockchain has opened up a way to change this in the future.
The introduction of smart contracts in blockchain platforms now allow assets like real estate to be virtually “tokenized” and be traded like “cryptocurrencies.” Because of this, blockchain could remove the need for Brokers, Lawyers and Banks. Blockchain can assume functions such as listings, payments, and legal documentation on a real-time basis. Cutting out these intermediaries will result in buyers and sellers getting more out of their money, as they save on commissions and fees charged by third parties, and also makes waiting periods caused by human delays and interactions non-existent. All of this could lead to a more inexpensive and efficient way to buy and sell property without dealing with banks or other slow processes.
A future with A.I. We have all heard of Artificial Intelligence and have seen it implemented in many different parts of our life such as smart cities, big data mining, Siri, Tesla, Alexa, etc. The future of A.I. is very bright and its limits are endless. As of now humans have just scratched the surface of Artificial Intelligences uses. As for real estate, there are already opportunities to use A.I.
Machine learning can help with property management by detecting suspicious spikes in energy use by analyzing weather data to give managers ways to save money. As for selling homes, A.I. can find homes that clients would like, much faster and easier than any human. With an input of data, it can use algorithms to determine every listing that falls into predetermined categories. It can learn more about the client and use A.I. to determine brick colors, appliance, layout designs, size, yard, etc. In the future, home selection, commercial site selection, etc. will be a far more accurate and quick process with the use of A.I. Those who use this technology will be able to anticipate rent, expense, and sale price fluctuations, or identify the perfect timing for selling property to optimize returns. Real estate, as a whole, is normally late to innovations. Being a first adopter to these new technologies will give you a true advantage.
Embrace the Change – Be an Early Adopter
In the coming years, the real estate space will be seeing some major changes. Yes, there will be some difficulties, but by and large, many great new opportunities will exist. The key for the coming decades will be to embrace and be a first adopter to change. With these advances happening so rapidly, what would have been months behind in the past, will now be equivalent to years behind in the future. New innovations will happen at an even faster rate, and if you do not adjust fast enough, you will be left in the dust. So, go out there and create a better future for yourself!
Public-Private Partnerships: A Tested Method for Today’s Opportunities
The concept of privatizing public services has the ability to create skepticism and controversy among the laymen. However, public-private partnerships (PPP) have been part of the fabric of American history since its inception. Simply put, a public-private partnership occurs when the public sector (the government) and the private sector (business or private entity) enter into a partnership in order to achieve a goal – either providing a service or engaging in a project. There have been countless examples of such partnership dating back to the Age of Exploration when new routes were discovered by daring explorers, to recent times when waste management, water, and other public services are provided for by private companies. This type of partnership is what has allowed humans to continue making progress, as it relies on the expertise of a private organization to get specialized work accomplished while the governing bodies can ensure their constituents will be entitled to the benefits.
Public vs. Private Good
“Public Goods” are defined by two characteristics – “non-excludability” and “non-rivalrous” consumption. This means that it is a good or service that generally is not performed for a profit, can be used by a number of people at the same time, and is not hinged upon payment consideration. An example of this would be the number of public services including national defense, police, fire, public safety, national parks, etc. On the other hand, “Private Goods” are the exact opposite. This means that a profit motivation can be realized, and that the good or service is based on expected payment. An example of a private good would be any consumer goods for purchase such as a sandwich or a candy. Of course, like most things in life, the line between private goods and public goods is not always clear. In fact, the following graphic provides a strong analogy for how things are often more complicated than initially perceived. Just as the colors commingle, there are opportunities that arise for privatization and public-private partnerships to add value to all parties involved.
Outsourcing
The most basic type of public-private partnership occurs when a government agency outsources a specific function – whether operations, management or maintenance – to a third party provider. Outsourcing in this way allows the public to benefit from a particular private company’s expertise, competitive bidding, economies of scale, etc. in a given area, without necessitating that the representative government become an expert in that same area. In general, this allows government entities to maximize utility and efficiency for each taxpayer dollar spent.
Many progressive cities are now reviewing the list of services and determining if they can reduce overhead, while ensuring that services are performed for constituents. In the past, many cities would take the position that the public sector was there to perform the services that the private sector would not or could not perform. This might be correct for services such as police or fire. However, other services once viewed as solely public sector are being looked at in a different light now that the private sector has created a public-private industry.
In this regard, most citizens turn on the water and assume that the city is responsible for its taste, clarity, and odor – especially since they typically receive a water bill from the city. Likewise, since a wastewater charge is included in the city’s water bill, citizens assume that the city is providing that service as well. However, just like with solid waste management, these services are undertaken by a private company that the city enters into a contract to collect the solid waste, manage water, treat the wastewater, etc. The city does not sell any assets, and they generally maintain the ownership of the pipes in the ground as well as the wastewater treatment facility. Additionally, they still own the water or other groundwater rights within the city.
Simply put, municipalities have proactively been seeking partners to help provide basic services in order to free up resources and concentrate on expanding their municipalities. They are no longer simply in the business of providing the services of water, wastewater, tax collection, etc., although they maintain responsibility and control through outsourcing. This means that instead of the city manager or mayor worrying about compliance with EPA or state environmental quality issues for the water, they can now devote this time to unifying a community over controversial issues, driving economic development, enhancing public safety, or outlining a plan for the city’s future.
PPP Financing Mechanisms
For a developer, the advantage of entering into a partnership with a public entity is that it decreases the developer’s risk by filling in financing that would otherwise need to be covered by a developer’s own investment in a project. Therefore, a developer can minimize the firm’s exposure and maximize the internal rate of return through this type of partnership. While not all partnerships are equal, working together to forge a public- private partnership could lead to a win-win scenario for both the public and private entities.
Most importantly, by creating this partnership, the private entity then gains access to additional public finance resources that can help to cover different aspects of a project’s costs. Combining several of these sources can add up to a substantial sum. The keys to this method are (1) creating the partnership; (2) well-defined project perspective, objectives and goals; (3) detailed agreement between the public and private entities; (4) creative thinking in matching up existing public funding with the needs and qualities of the proposed project; and (5) willingness of each partner to help meet the other partner’s needs. Though there are various financing mechanism available, the following list highlights the several major types utilized for real estate-specific assets:
Tax Increment Financing (TIF): The most frequently utilized mechanisms in PPP earmarks estimated increases in property and sales taxes in a designated geographic area (a “District”) to underwrite public improvements related to development in the area. This can be done by creating a quasi-governmental body which manages the TIF by issuing bonds to pay for the public improvement. These TIF Bonds may then be issued and repaid with the incremental increase in taxes to be realized and captured within the TIF District. Often, the area designated as the District is considered to be unimproved, blighted or underdeveloped.
Payment in lieu of tax (PILOT): In a PILOT program, the developer shifts ownership of real property to a tax-exempt entity, such as an industrial development board. The developer then agrees to make a payment to the tax-exempt entity in an amount that the developer would have been required to pay were the real property not tax-exempt. The tax-exempt entity then uses the PILOT payment to fund the construction of public improvements within the development. As with TIFs, a PILOT can also involve a bond issuance.
Public Improvement Districts (PID): Also known as Community Improvement District (CID), or a Municipal Management District (MMD), a PID/CID/MMD is a taxing entity which can finance, construct and maintain public improvements. A PID may be formed to address any type of public improvement or service. It has authority to issue debt and impose a mill levy against real and personal property within the district. PIDs are typically empowered to finance infrastructure such as sidewalks, streets, water & wastewater lines, bridges, and drainage improvements.
Community Development Block Grants (CDBG): Designed by HUD to provide communities with resources to address a wide range of development needs, the CDBG program provides annual grants on a formula basis to local governments and states.
Tax Exempt Financing: Due to a number of legislative initiatives over the past decade, several areas across the country have been designated for tax incentives, including tax- exempt financing, as part of redevelopment. These zones allow for tax-exempt bonds to be issued in support of redevelopment projects. The most recent examples are the Opportunity Zones that have been established by the Trump Administration.
Tax Credits: Tax credits exist on local, state and federal levels, and can be combined to increase the equity in any real estate development project, as well as to reduce the exposure of a developer in a given project. They take many forms, and are targeted to achieve different policy objectives, such as economic development of low income areas, brownfield rehabilitation, or energy efficiency.
Environmental Grants/Underwriting: An area of underwriting that exists to assist developers in creating environmentally friendly projects. Including green space in a development and maintaining wildlife habitat can potentially qualify a project for federal funding that is administered by state wildlife agencies. Some programs that could potentially qualify for funding include reclaiming waterways, protecting woodlands, preserving natural habitat, creating energy efficiency and coastal preservation.
Case Study: Sugar Land Town Center
An example will illustrate the economic benefits of a Public-Private Partnership, giving particular attention to the general economics of these successful developments, by comparing “traditional” economic structures with only private equity to those that include a public sector capital contribution as a result of a public-private partnership.
Sugar Land, Texas utilized a public-private partnership to develop its mixed-use Town Center, contained on 32-acres of land, and summarized as follows:
Below is an analysis of what the Sugar Land Town Center development would have looked like without public incentives. This structure will be called “traditional” as it is compared to a public private partnership.
Based on current revenue, expense, and market valuation techniques, the following is the anticipated value and internal rate of return on the (traditional) equity, assuming that the assets were sold roughly four-years after the start of construction:
Following the repayment of the traditional debt (70 percent loan-to-cost) the net cash flow from the sale of this development would yield roughly $89 million. Based on the initial (traditional) equity investment of $56 million, this return, over the four year investment horizon, equates to approximately a 17 percent internal rate of return. For a traditional real estate investment, particularly one that requires $56 million in equity, that is not that attractive of a return, after adjusting the investment for risk.
For many real estate equity investment funds, a minimum threshold for internal rate of return should be 30 percent – far above the 17 percent in the above “traditional” equity structure. Consequently, since there may not be any room for cost or expense reductions, or even revenue enhancements, the only way to increase the internal rate of return would be through leverage.
This leverage was found through a partnership with the city of Sugar Land, as the city had a desire to see the development succeed for a variety of visionary reasons. Indeed, the plan met the public sector’s desires to shape its future and achieve a particular vision of what life should look like for its citizens.
Thus, the financial structure of the development under the public-private partnership was as follows:
For the developer, the city’s contributions made a significant positive impact on its internal rate of return. The capital structure, including the impact of these incentives was:
As a result of the city’s incentives, the developer’s equity investment was reduced from $56 million, to $34 million.
Following the repayment of the traditional debt (70 percent loan-to-cost) the net cash flow from the sale of this development would yield roughly $89 million. With the developer’s equity investment of $34 million, over the four year investment horizon, this finance structure results in approximately a 37 percent internal rate of return.
Due to the city’s incentive package, the developer was able to increase the internal rate of return from 17 percent to 37 percent. Consequently, the finance structure under the public-private partnership for the Sugar Land Town Square development made the project economically feasible solely as a result of the incentive package offered by the city.
Win-Win Solution
What does all this mean? Municipalities are beginning to craft their own visions of what they want their futures to look like – from small towns to large cities. Often times, these vision statements are paired with development incentives or economic development funds that aim at facilitating the realization of this vision. This rings to be even more true when the typical cash resources become limited during questionable economic times. Public entities will look to lean into more PPP’s, to help continue development and growth in the communities. For the private organizations that participate, benefits will be apparent as the Public contributions usually come in form of a grant which doesn’t need to be paid back or cause dilution in ownership. Both of these benefits shave a direct impact on the return developers can produce for their investors. However, these project’s success is usually heavily relied upon the strong relationship forged over years of working together between both private and public sectors. Organizations with these relationships will not only get the opportunity to thrive even in concerning economic climates, but also enable both sides of the table to utilize their strengths to move the needle on human progress.
You can follow the blog to see what else David Wallace writes.