The future of value-add and opportunistic investment in commercial real estate assets is almost exclusively dependent on a general economic recovery.
The primary conversation in the commercial real estate market today revolves around the substantial amount of equity capital chasing high-quality core investments as prospective buyers exhibit a high level of interest in the stability of income and an overall lower risk level. For reasons that have yet to be fully explored, there is comparatively little discussion of value-add and opportunistic space.
Value-add and opportunistic investments traditionally have been considered higher-risk strategies that use significant degrees of leverage to maximize the total return of an investment. Value-add opportunities generally involve Class B or C assets in high-quality locations that can be significantly improved operationally or rehabilitated to increase cash flow. Leverage approaching 65 percent can be used both to enhance returns and to finance part of the renovation capital.
Opportunistic investments are even riskier, and generally involve assets with very volatile or depressed cash flows that can be repositioned by introducing a new use, investing a significant amount of capital to reestablish cash flow, or engineering a complex capital structure to leverage the equity even higher (over 65 percent) and accelerate investor returns. These investments cover a wide spectrum of opportunities, and can range anywhere from Class B through Class D assets to groundup development located in primary through tertiary markets.
Institutional private equity funds emerged to be some of the largest participants in the value-add and opportunistic market. Early activity focused on distressed debt being liquidated by the Resolution Trust Corporation following the savings and loan (S&L) crisis in the 1990s, then moved to banks, insurance companies, and other financial institutions. Once the market stabilized and liquidity returned, buying moved to existing real estate, then to development, and even to foreign investment. Targeted gross leveraged returns for value-add investments would generally range from 15 to 20 percent, with returns for opportunistic investments exceeding 20 percent.
In the 2000s, as funds continued to achieve these levels of return, they found themselves competing with more and more equity in a world with fewer traditional opportunities. At the same time, as allocations to real estate were increasing, the floodgates of debt capital opened wide with cheaper funds and less rigorous underwriting standards.
As a result, some value-add and opportunity funds began venturing into what had previously been the realm of the core investors, but employed extraordinarily high levels of leverage coupled with optimistic underwriting assumptions in search of opportunistic returns through a bet on residual values and the ability to refinance maturing debt. Other funds elected to move into riskier execution strategies such as ground-up development. Today, the results of this activity are clear, and some investors who participated in these transactions during the peak of the cycle have lost some or all of their equity.
In stark contrast with the core marketplace, transaction volume for value-add and opportunistic investments remains extremely low. This is principally attributable to four factors:
- a continued fear of execution risk by lenders and equity investors;
- a lingering spread between what buyers are bidding and sellers are asking, due in large part to an expectation that returns in this down cycle would be similar to those of the late 1980s and early 1990s;
- a willingness of lenders to extend or work out problematic loans; and
- a lack of attractively priced debt.
An especially challenging task for most real estate investors and lenders today is to underwrite a robust recovery scenario for a particular investment. The difficulty of this is exacerbated in the value-add and opportunistic space because a buyer is required to make assumptions regarding the ability to lease up vacant space over a particular period and at a specific rate in an environment typified by limited lease activity and declining rental rates. The fear of underwriting value-add and opportunistic strategies has limited buyer demand.
A general perspective of the market over the past 18 to 24 months was that the current down cycle would produce returns similar to those experienced during the late 1980s and early 1990s. While this still may occur, the most recent history has not demonstrated the ability to achieve these types of returns, thus establishing a fairly significant bid/ask spread between buyers and sellers of value-add and opportunistic real estate that has yet to be overcome.
A common theme throughout the current economic crisis has been the willingness of lenders to work through problems with their borrowers. Unlike the experience during the S&L crisis, banks are unwilling to discount loans only to see buyers reap the upside of acquiring the assets cheaply. Both lenders and well-capitalized borrowers are electing to extend the current situation, aided in large part by extremely low borrowing rates tied to the London Interbank Offered Rate (LIBOR) and relaxed mark-to-market rules and capital requirements for banks. By deferring the foreclosure process, both groups hope that fundamentals will return and allow for a recovery in asset values.
Capital markets in general are rebounding, as shown by the recovery in public equities over the past year and the narrowing spreads on debt instruments. Since the beginning of the year, a totally different lending environment has evolved for borrowers seeking debt capital on core assets as lenders begin to reenter the market for high-quality assets with reasonable loan terms.
The availability of attractively priced debt in the value-add and opportunistic market, however, has remained fairly limited because these same lenders remain wary of lending on assets that have not stabilized in value. Debt funds and mortgage real estate investment trusts have filled some of this gap, though the interest rates are generally above 10 percent. Such high debt costs have inhibited the value-add and opportunistic market because investors are unable to get desirable returns. In rare instances, some groups are electing to fund the investment entirely with cash rather than pay high rates of interest.
Because of these issues, very few value-add and opportunistic transactions have occurred since the start of the year. Banks and special servicers have been disposing of nonstabilized assets in the market, but these transactions are generally of such low quality that there is minimal interest among larger investors. Deals that have been done have been smaller and financed creatively through vehicles such as low-interest-rate lines of credit.
The future of value-add and opportunistic investment is almost exclusively dependent on a general economic recovery. The weakening of the global economy has reduced demand for space around the world and increased uncertainty regarding investment returns. In particular, major job losses have largely undone a decade of employment growth and muted widespread demand for commercial real estate for the near future.
Unlike the oversupply problem that led to the S&L crisis, the recent collapse in commercial real estate is due to a combination of excess leverage and a precipitous drop in demand. Therefore, value-add and opportunistic transactions appear to be almost at a standstill because potential buyers are not participating in the market or because tighter underwriting has led to a bid/ask gap between buyers and sellers. Moreover, without reasonably priced leverage available in the 65 to 80 percent range, value-add and opportunistic investors are finding it extremely difficult to identify opportunities in which pro-forma returns are able to meet current investor expectations.