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Value-add, often called opportunistic, investments are a way tobreathe new life into existing real estate. By redeveloping,repurposing or performing adaptive re-use on properties that havebecome tired and/or obsolete, developers can create brand-new,desirable assets in supply-constrained markets that are craving newinventory and also generate greater profits for their investors.The practice has become a way for every type of investor from REITsto high-net-worth individuals to achieve the yields they seek inheated markets that have become overrun with domestic and foreigncapital, which has forced prices up and compressed cap yields. It'salso become nearly the only type of development seen in marketswhere developable land is scarce and expensive, such as most ofSouthern California. When core assets are out of reach or simplydon't make sense, value-add plays are a smart alternative for yieldacross all property categories—so much so that many commercial realestate investment and development firms are focusing primarily onthese opportunistic ventures over core assets.

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Value-add investments can be made in property, funds and jointventures, providing a wide menu of choices with almost immediatepayoff once the renovations are complete. “Value-add andopportunistic investments offer the chance to get near-termdouble-digit returns, which is now almost impossible withstabilized commercial real estate assets,” Solomon Poretsky, VP oforganizational development for Sperry Van Ness International Corp.,tells Real Estate Forum. “While they're perceived as riskier thanstabilized properties, assuming that the value is there to add,they actually provide important downside protection since, ifvalues do drop in the future, they could still end up with a netgain. For example, a $20-million asset that has $10 million invalue added and then loses $8 million in a correction is stillworth $22 million (20+10-8)—a 10% increase. A $30-millionstabilized asset that loses $8 million in value in a correctionends up losing about 27% of its value.”

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For Carter, a real estate investment, development and advisoryfirm, there has always been an appeal to opportunistic investmentsbecause of a higher adjusted return, Jim Shelton, the firm's vicechairman, tells Forum. “Obviously, if you are buying core returnsthere are lower yield expectations, but as you evolve to core-plus,value-add and opportunistic investments, each has a higher riskprofile and theoretically pays a better return. Typically, you seeinvestments in this category with investors wanting to diversifyand climb up the risk spectrum to improve yield.”

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Some property types that are in high demand—industrial, forexample—draw investors to opportunistic investments. “Nearly allinvestment funds are under-allocated to industrial real estate, andthere is a wall of capital trying to get into California industrialdue to its perceived safety as an investment class within thebroader real estate market,” says Jon Pharris, co-founder anddirector of acquisitions for CapRock Partners. “With industrial caprates around all-time lows, value-add and opportunisticacquisitions allow capital to diversify within industrial realestate and pick up additional yield with only a slight increase inrisk. It is a favorable trade-off.”

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In fact, first and foremost, investors seek value-add andopportunistic investments as yield generators, Robert Dougherty,partner at Buchanan Street Partners, tells Forum. “For better orworse—leverage being a double-edged sword—real estate presents aunique asset class in this regard compared with other opportunisticinvestment strategies (e.g., M&A activities, corporateinvestments, etc.) because real estate investments are underpinnedby hard assets. This offers the prospect of favorable leverage inspite of substantial value creation left to implement. Naturally,the same downside protection afforded by real assets that thelenders seek favors the investor as well—provided that investmentsare not over-leveraged. The debt markets appear to have a moreactive governor in this cycle vs. the last. Regulators and B-piecebuyers are keeping debt underwriting sane, saving opportunisticinvestment managers from themselves—so far, at least.”

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Value-add investments also appeal to an investor/developer'screative side, which has become the buzzword of choice in newdevelopment. “The appeal to a purchase of a property that has avalue-add play is the opportunity to get creative and add tenants,update the façade, build an outparcel, etc., to increase the NOIfrom when the property is purchased so that when they go back tomarket to sell the property, the price increases,” relates BryanBelk, director of Franklin Street Real Estate Services.

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Many funds like the diversity that value-add investments offerthem. Waterton Associates, for instance, is on its 12th value-addmultifamily investment fund and is currently actively investingthat fund, CEO and founder David Schwartz tells Forum. “Theadvantage for that type of vehicle is that they are geographicallydiverse. We will buy 35 properties, and they will typically be in15 different markets. We curate our portfolios—we generally don'tbuy portfolios unless we like all the properties—and the propertiesrange from deep value-add (adaptive re-use or stalled constructionprojects where we've completed them and built out the units) tolight value-add where we may update kitchens and common areas. Youget some higher-risk, higher-reward assets and some lower-risk,lower-reward assets, and it's a nice combination, but at the end ofthe day, the portfolio should have great locations and be good realestate.”

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Often, opportunistic investments are most popular during andimmediately after a recession, economic downturn or low end of areal estate cycle, but how do they fit in at other points in thecycle? “Value-add is usually popular during and right afterrecessions because it's easy to do,” says Poretsky. “Good buildingsthat fall on bad times are usually great acquisitions, and all thatthe owner has to do is wait for the right time to extract the valuethat he or she adds by stabilizing the asset. In good times, it canbe harder to find a distressed asset, but, if you can find one,it's that much easier to extract the value. Ultimately, there arealways opportunities to create value in the market.”

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The challenge has always been predicting where exactly in theeconomic cycle we are, and that can be difficult, says Shelton.“The later you go in the cycle, the harder it is to find value-addopportunities, which means that you've got to be more creative toachieve the returns you desire.”

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Pharris says in any cycle there are value-add acquisitions, “butthe nature of the opportunity changes as the recovery advances.Early in the recovery, the value-add may be REO or non-performingnotes; then it can progress to partially occupied buildings orshort-term leases; and then it may advance to buildings with excessland or converting non-functional buildings to higher and betteruses. The key is with that there is always opportunity, but it isimperative to know the stage of the cycle so that the investmentthesis can adjust.”

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True value creation activities such as lease-up, renovation,rebranding and repurposing should offer enhanced yields regardlessof the market cycle, says Dougherty. “Too often, however, merelyriding a market wave or exploiting cheap debt is accepted as'value-add' activity.”

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Belk, too, believes value-add activity is always popular nomatter what part of the cycle we're in. “Investors are alwayslooking to increase the value of their portfolio by looking forassets where tenants' rents may be under market or spaces may bebetter used for other tenants that have a positive effect on thevalue of a shopping center.”

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Schwartz disagrees that value-add plays are more profitableduring or immediately after a recession. He adds that investors canoften get better prices on value-add investments at those points inthe cycle, but it can also be more difficult to lease up renovatedapartments and achieve desired rent growth when the economy isdepressed. “[Buying at low prices] is the opportunity. Butironically, renovating units out of a recession can be toughbecause no one really wants to pay the rent [on an upgradedapartment unit]. In 2010, people were willing to accept units theway they were, so value-add didn't work everywhere. At that time,we weren't doing renovations in all markets because you couldn'tget the premium. Fast-forward to today, when the market isextremely strong, and you have a record disparity between new andold product—the rent differential between new and old product is ashigh as it's ever been recorded. So, in the strong part of thecycle, you're getting much better return on dollars invested invalue-add. We think the market is very good now, and when you thinkabout it, when you renovate an older property in a good locationand the rent is $400 below new construction, it's a great valueproposition for the market, and there's a lot of demand forit.”

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Despite the upside, there are some common mistakes investors invalue-add make that can curtail their success and drive downprofits. “The key to opportunistic investment is in due diligence,”says Poretsky. “Returns are largely locked in the day that you buythe asset. If you don't know what you're getting into and end upwith delays, unexpected costs or unforeseen challenges in tenantingthe property, the property goes from 'opportunistic' to 'mistake'very quickly. The more up-front research an investordoes—especially leveraging local market experts from the brokeragecommunity—the more likely the deal is to hit projections.”

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Shelton says in the later stages of an opportunisticenvironment, from an underwriting standpoint people tend to becometoo aggressive with debt and end up overpaying and overdeveloping.“They may also venture into areas where they don't have as strong alevel of experience.”

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Pharris says being over-leveraged is one of the biggest mistakesmade in opportunistic investments, and Dougherty agrees. “Far andaway, the biggest mistake made with opportunistic investments isover-leveraging them. It is ironic that many investment managersand their clients have their leverage strategies backwards. Theyover-finance the riskier, more volatile value-add/opportunisticinvestments and don't borrow significantly against their safer coreassets.”

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Schwartz says some investors make the mistake of paying morethan reproduction cost for value-add assets just to get in thegame. “Why would you buy a value-add property that would cost youmore when you're done than a brand-new asset? It makes no sense tome, but you're seeing it. It's the valuation issue you have to becareful of—it's difficult to find good, well-located property andbuy it below replacement cost, but that's what we look for tobuy.”

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Underestimating the cost of doing value-add is another frequentmisstep, says Schwartz. “This comes from not properly conductingdue diligence and figuring out what it costs to do it right. I seeso many value-add renovations done on the cheap, but thecustomer—the resident—is very smart. When they see arenovated apartment done with cheap materials, poor quality andworkmanship, they're not going to want to pay for it. Some peopleskimp out on quality and overly value engineering, and the customerdoesn't go for it. And often, with older assets, they're notlooking behind the walls enough to find problems in plumbing andelectrical. You get no return on that capital investment, but youstill have to spend the extra money, and if you miss those they'rea killer.”

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Another common mistake is seeking yield in tertiary markets,says Dougherty. “The timing of these plays is extremely dicey. Theyare last-to-rise, first-to-fall markets, and their 'day in the sun'for institutional liquidity is often a short, unpredictablewindow.”

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Belk says not doing proper research on a market is a hugemistake investors make in their search for yield in value-addinvestments. “Many times when investors see vacancies, they thinkopportunity. A lot of times there is a very good reason why a spaceis vacant; i.e., the submarket is shifting or a traffic pattern ischanging.”

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Creating improper alignment of interests is another frequentpitfall in value-add investments, Dougherty says. “Capital partnerscan find themselves at odds with operators with too little skin inthe game and a fee revenue stream to protect. This can lead tomisalignment of fiduciary responsibilities. Complex financialstructures may have the same impact when one party ends up out ofthe money unexpectedly vs. a pari passu arrangement.”

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Paying less for a value-add asset than you would for a coreproperty is no excuse for poor due diligence and imprudent realestate practices. Making these mistakes can erase any gainsinvestors might have made in these plays, but approaching themwisely can yield great results.

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Carrie Rossenfeld

Carrie Rossenfeld is a reporter for the San Diego and Orange County markets on GlobeSt.com and a contributor to Real Estate Forum. She was a trade-magazine and newsletter editor in New York City before moving to Southern California to become a freelance writer and editor for magazines, books and websites. Rossenfeld has written extensively on topics including commercial real estate, running a medical practice, intellectual-property licensing and giftware. She has edited books about profiting from real estate and has ghostwritten a book about starting a home-based business.