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COMMENT: Looks can be deceiving

The vast majority of institutional investors remain fixated on core real estate despite continued cap rate compression and declining returns. So why are so few looking elsewhere?

Everyone can spot a beauty, but far fewer people can spot a beauty in the making. BlackRock, the New York-based asset management firm, is positioning itself to be in the latter camp.

In fact, Simon Treacy, global chief investment officer and head of US equity of the firm’s real estate business, touted the benefits of ugliness at a recent press event.  “One play that we really like with our on-the-ground teams is to buy ugly or rundown buildings that really haven’t had a lot of cap ex put back into them for whatever reason, and we refurbish and reposition them as core, income-producing properties again,” he said.

Shiny trophy properties in global gateway markets may grab a lot of headlines and attention from investors around the world. However, amid the influx of cross-border capital into those cities, the competition for such prized assets has driven up pricing to such lofty levels that it is becoming increasingly difficult for many of those institutions to reach their return goals. Meanwhile, in those same cities, there are tens of thousands of properties that also are well-located but lacking suitors because of their aging, often unattractive appearance.

Such assets are a sweet spot for firms like BlackRock, which typically look to reposition and upgrade such buildings from Class B- to a B+ or A-. Such B-grade buildings have been overlooked by a lot of investors, particularly large institutions. “With an ugly building, you can get a much better price on a more exclusive basis,” said Treacy, whose firm operates in 17 global gateway cities. “We want to go fishing where other people are not fishing. That’s the strength of BlackRock’s platform.”

While some investors already have been moving up the risk spectrum in search of a higher return and therefore may be open to a value-added strategy like BlackRock’s, not everyone has made that shift. Many institutions still are resolutely core-focused, and they will need more convincing to consider ugly buildings as an investment opportunity.

In some ways, it’s understandable why some investors still are clamoring for core properties, even when the returns don’t necessarily justify it. Some institutions, after all, want core for diversification purposes, while others got hammered by their non-core investments during the global financial crisis and still haven’t forgotten the pain of those losses. Those investors don’t have the appetite to take on the risk of refurbishing an ugly building because of the uncertainty involved. They want a building that already is stabilized and more of a sure bet.

Still, given how tightly compressed cap rates for trophy assets are now and the expected rise of interest rates, it may be time for more institutions to rethink how they view ugly buildings. While trophy assets may be pretty, the returns may no longer be as attractive. Indeed, looks can be deceiving.