Investopedia

The Investors Guide To Finding A Diamond In The Rough

A few years after the end of the Great Recession, the investment landscape is still tricky. The stock market continues to be volatile, while bonds post a skimpy 1 – 1.5 percent rate of return. But real estate remains a stellar portfolio asset, and that has investors clambering for attractive opportunities.

In fact, a typical core asset—an existing structure that needs no improvements before renting or leasing—can bring respectable returns of about 5 or 6 percent. For a retiree looking to bolster a retirement fund, core assets can provide a stable, predictable cash flow.

Others assets carry higher upfront risks with the potential of greater returns. These value-added assets often need to undergo some sort of major renovation or improvement before renting or leasing. But the risk can pay off in the form of a higher annual return. Some value-added properties can offer returns as high as 20 percent.

In an improving economy, investor demand for value-added assets has intensified. In primary markets, like New York, Los Angeles and Chicago, these kinds of assets have become scarce, pushing investors into secondary markets like Seattle, Salt Lake and Denver. But great opportunities exist in these markets for savvy investors. The trick is finding those assets and knowing how to maximize their potential.

GOING STRONG

Rawley Nielsen, president of investment sales with CBC Advisors, sums up the current real estate investment market in one word: “Insane.”

Nielsen says the market shows strong activity in every product type and along every spectrum, from stable core assets to riskier value-added plays. “We’re now above where we were in 2006-2007,” he says.

The real estate investment market, overall, is offering historic-low cap rates, according to Mary Street, associate broker, land and investments, with CBC Advisors. In the late 1990s, she says, most investments were priced at a cap rate of 10 percent. “Prior to the recession, we saw cap rates drop to an average of 8 to 8.5 percent. During the recession, in some sectors we saw dramatic increases as a reflection of increased risk caused by vacancy and market uncertainty.”

Beginning in 2012, cap rates began to compress downward again. Now, for example, cap rates for multi-family properties are at historic lows, typically between 4.5 and 6 percent.

“We have a lot of investors seeking small apartment communities, as those are still considered safe, stable investments,” says Street. Small office buildings and industrial buildings are also in demand. “Opportunistic investors are hungry for those assets. But they require an investor who is willing to be a little more involved.”

Secondary and tertiary markets are seeing a lot of new interest from national and international investment firms. “When the market is hot, international investors pour into the primary markets. That pushes big, national firms into more secondary markets, as they go looking for opportunities. What that does in local markets is push the smaller investor into even smaller markets, or to more value-added properties,” says Nielsen. “It makes it very difficult for local investors to buy local products.”

Nielsen recently represented the seller of a shopping center in Provo, Utah—a smaller, tertiary market. The center suffered from some fairly severe problems: It had a vacancy rate of 30 percent, was poorly designed and quite run-down. “We immediately had 15 offers, and only two were from within the state,” he says. “We ended up selling above asking price.”

That overwhelming demand is requiring smaller investors to work harder to identify quality investment opportunities. “People will stretch to do deals they wouldn’t have done two or three years ago,” says Nielsen.

Screen Shot 2016-08-29 at 9.36.17 AM

DIAMOND IN THE ROUGH

It’s fairly easy to find a run-down strip mall or aging apartment community. What’s not so easy is identifying the properties that have excellent upside potential.

The first step, says Street, is to pull together a team of advisors to guide every step of the process. That team should include the investor, the real estate broker, a banker, a financial advisor and/or accountant—to advise on tax and investment strategy issues—and a general contractor for inspections and potential renovations. After purchasing the property, the investor may also need an architect for redesigns.

The next step is to analyze the location of any potential asset. While that seems like a no-brainer, it actually requires a deep dive into the surrounding community. Street says to look for the anchor institutions around the asset—things like hospitals, high schools or major shopping centers, which will keep the area lively for years to come. What are the long-term development trends in the area? What is the long-term usability and re-usability for the property?

Factors such as traffic counts, population growth projections, demographic studies and economic feasibility studies all must come into play for an investor looking to acquire a value-added asset because of the greater risk involved, according to Adam Gatto, a founding member of G&G Investment Advisory Group of CBC Advisors.

Projected population growth is one factor that led Fundrise, a Washington D.C.-based investment firm, to invest $2.5 million of preferred equity in The Bonneville, a new luxury apartment building being constructed in downtown Salt Lake City. The Class A 158-unit luxury apartment building offered Fundrise a projected 14 percent gross annual return on a 36-month term investment.

“One of the things that’s great about Salt Lake City versus many of the other core or secondary markets is that it has so much natural growth,” says Ben Miller, CEO of Fundrise. “It has population growth. It has business growth. It has Google Fiber. We like the fundamentals about it.”

The next thing to look at is the market for the product type, says Street. Are rents increasing, decreasing or stable? What is the trend for vacancy rates? Are there new buildings coming onto the market in the near future?

Investment firms or experienced individual investors can look at a neighborhood and predict with comfortable accuracy at what level rent and occupancy rates will be over a three- to four-year period, says Miller.

The last element in finding the right value-added property, says Street, is assessing your own investor profile. What is your comfort level with risk? How long will you own the property? How involved do you want to be in improving and managing the property? How much money do you want to put into the investment? Your real estate broker should be able to walk you through these questions to help pinpoint exactly what kind of investment fits your profile.

Screen Shot 2016-08-29 at 9.37.44 AM

ROLL UP YOUR SLEEVES

Of course, finding and purchasing the property is just the first step when investing in value-added assets.

“It basically involves buying a property, improving it in some way and selling it at an opportune time for a gain,” Gatto says. “Usually when someone is looking at a value-added opportunity, maybe the property itself exhibits management or operational problems. It may require some physical improvements or it is suffering because of capital constraints.”

Often, value-added properties suffer from high vacancy, unaddressed maintenance issues and management problems. Retail centers, for example, usually undergo an exterior refresh every decade or so, says Street. When that does not happen, the center looks dingy and old—and unattractive to potential tenants. In apartment buildings, managers can neglect to renew leases with long-term tenants, who simply become month-to-month renters. Properties of all kinds can accumulate maintenance problems, from minor to severe issues.

In one strip mall, the buyer was dismayed to learn the entire HVAC system needed to be replaced, says Street. The seller had discounted the purchase price in acknowledgement of the HVAC issues. In order for the buyer to pay for the $100,000 in repairs, the cost was added to the sale price to create an escrow account for the buyer. This enabled the buyer to purchase the property, make the repairs and immediately begin seeing rental revenue. And the cap rate on the property held firm at about 9.5 percent.

If the investor can’t afford to completely renovate the property from the get-go, they can make incremental improvements. Updated signage and landscaping are an easy first step. Less severe repairs can be made a bit at a time, until the property is in top shape. If rents are low, incremental increases will bring them up to market rates. Especially for retail properties, it may be important to weed out

Especially for retail properties, it may be important to weed out less-desirable tenants. This can be accomplished easily by not renewing leases on tenants you don’t want there anymore. In the meantime, Street says to actively seek out tenants that are a fit for your property. One of her clients purchased a retail center across the street from a high school. The center had some tenants that were not compatible with the school—a smoke shop and a tattoo parlor. Instead, the investor sought out tenants he thought would be successful in that location, like a pizza place, a party supply store or an ice cream shop. “He basically hand-picked the tenants he wanted in his retail center,” says Street. FAST FORWARD Make no mistake: investing in value-added real estate assets entails a commitment of time and resources. It’s riskier, and Gatto says it can take five years to a decade to fully realize an expected return. But for those investors with the time and patience—and a solid team behind them— the strategy can provide ample reward. Looking forward, Street expects the investment market to remain very strong. She says cap rates should remain low throughout 2016. “I don’t see interest rates rising enough to impact commercial real estate,” she says. “The real estate market is as strong as we’ve ever seen it.”

One of her clients purchased a retail center across the street from a high school. The center had some tenants that were not compatible with the school—a smoke shop and a tattoo parlor. Instead, the investor sought out tenants he thought would be successful in that location, like a pizza place, a party supply store or an ice cream shop. “He basically hand-picked the tenants he wanted in his retail center,” says Street. FAST FORWARD Make no mistake: investing in value-added real estate assets entails a commitment of time and resources. It’s riskier, and Gatto says it can take five years to a decade to fully realize an expected return. But for those investors with the time and patience—and a solid team behind them— the strategy can provide ample reward. Looking forward, Street expects the investment market to remain very strong. She says cap rates should remain low throughout 2016. “I don’t see interest rates rising enough to impact commercial real estate,” she says. “The real estate market is as strong as we’ve ever seen it.”

“He basically hand-picked the tenants he wanted in his retail center,” says Street. FAST FORWARD Make no mistake: investing in value-added real estate assets entails a commitment of time and resources. It’s riskier, and Gatto says it can take five years to a decade to fully realize an expected return. But for those investors with the time and patience—and a solid team behind them— the strategy can provide ample reward. Looking forward, Street expects the investment market to remain very strong. She says cap rates should remain low throughout 2016. “I don’t see interest rates rising enough to impact commercial real estate,” she says. “The real estate market is as strong as we’ve ever seen it.”

FAST FORWARD

Make no mistake: investing in value-added real estate assets entails a commitment of time and resources. It’s riskier, and Gatto says it can take five years to a decade to fully realize an expected return. But for those investors with the time and patience—and a solid team behind them— the strategy can provide ample reward. Looking forward, Street expects the investment market to remain very strong. She says cap rates should remain low throughout 2016. “I don’t see interest rates rising enough to impact commercial real estate,” she says. “The real estate market is as strong as we’ve ever seen it.”

Make no mistake: investing in value-added real estate assets entails a commitment of time and resources. It’s riskier, and Gatto says it can take five years to a decade to fully realize an expected return. But for those investors with the time and patience—and a solid team behind them— the strategy can provide ample reward. Looking forward, Street expects the investment market to remain very strong. She says cap rates should remain low throughout 2016. “I don’t see interest rates rising enough to impact commercial real estate,” she says. “The real estate market is as strong as we’ve ever seen it.”

Looking forward, Street expects the investment market to remain very strong. She says cap rates should remain low throughout 2016. “I don’t see interest rates rising enough to impact commercial real estate,” she says. “The real estate market is as strong as we’ve ever seen it.”