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Where have all the value-add deals gone now that we’re 10 years past the Great Recession? Certainly, there will be a new set of opportunities as a result of the economic shutdown from the coronavirus. However, the traditional apartment building in need of significant renovation in a quality submarket has largely vanished.
It seems like every apartment property on the market has been renovated to some extent. Fully renovated, partially renovated, sold two or three times or four tiers (silver, gold, platinum, insert your favorite precious metal here) of renovation packages seem to be a part of every offering memorandum we see. If you happen to see a property that hasn’t been touched at all, the pricing on that deal is likely even more expensive than one that has already been renovated (at least partially) and proven out.
The scarcity of value-add deals is real, and sponsors are stretching their definition of value-add to shoehorn deals into their strategy that otherwise wouldn’t fit the criteria. There’s such a lack of value-add properties available — ones that can generate returns of 15% or more — that many large institutional investors have shifted away from value-add and have moved toward core-plus funds.
Value-add sponsors are left with a difficult choice: Seek lower returns appropriate for the level of risk and lighter value-add work required (i.e., core plus), or find ways financially to improve the returns to the midteens. Unfortunately, I believe many have chosen to financially engineer the capitalization of their investments in order to keep satisfying their investors’ desire for higher returns. Debt funds aren’t shy about providing 75%-80% of the acquisition price plus 100% of the planned renovation capital.
We’ve also seen groups coupling this with preferred equity. Preferred equity is effectively another loan, but at a high current pay rate and with equity rights and priority if things go wrong. These both serve to lessen the “common” equity in the deal and provide even more leverage without calling it that. Since values and rents have only risen in this long economic run, demographics continue to favor the apartment sector, and now with interest rates at all-time lows, there hasn’t been much thought about the amount of risk actually taken.
For true value-add deals with significant upside, the capitalization methods above can make complete sense. Additionally, the amount of risk taken in a transaction like this warrants an outsized return, and, hopefully, all parties involved understand this. Alternatively, cautious investment groups who have noticed the dearth of true value-add deals and apply lower levels of leverage have reduced their return targets for value-add deals to the 12%-15% net range instead of 14%-17%. Some traditional value-add sponsors and syndicators (i.e., noninstitutional investors) are moving toward core-plus and longer-life investment strategies targeting roughly 10% net returns.
On the surface, these lower return targets don’t appear as compelling, but this realism has turned into a massive fundraising boon for the largest name-brand nontraded REITs operating with this approach. The stability of cash flow instead of relying heavily on appreciation has certainly struck a chord with the individual investor crowd.
Though the larger opportunity may lie in the core-plus sector and in longer-duration investments, the small syndicator or sponsor will have difficulty making the economics work. Lower-risk investments generally mean lower fees, lower promoted interest and a longer time to realize any meaningful upside. Also, with lower leverage, the equity amount needed to purchase a property is greater, and the fundraising capacity of the sponsor may be quickly stressed. This is a strategy where scale is important and portfolio size has a big impact on the viability of operators in this space. Accumulating a meaningful portfolio takes time or access to a significant amount of capital, both of which a smaller operator generally doesn’t have. Ultimately, this may not be the best route for many firms, and they’ll need to remain committed to the value-add space.
All is not lost for value-add dealmakers. There are still deals getting done — our firm recently found two of them. They both fit in the partially renovated category, and there’s enough operational upside, renovation potential and submarket growth for us to generate value-add returns, but at traditionally conservative debt levels.
Renovations done at the beginning of the cycle are now appearing dated and some owners just don’t operate to maximize profitability. Also, particular markets — such as Phoenix, Nashville and Austin, Texas — are still experiencing robust growth in jobs, in-migration and rents. There is no doubt that margins are tighter to execute the value-add strategy and that deal flow is thin, but staying true to the value-add strategy and thinking about how to best pivot to a core-plus alternative are ways to navigate the current environment.