Speak to real estate investment managers today and they will tell you how value-add strategy home-runs were more of a certainty during the early 2010s. The global financial crisis had provided a vast supply of distressed assets, while continuing low interest rates provided demand for both value-add products as well as the optimized assets that materialized from them.
Major markets have since recovered to levels where value-add strategies no longer can rely on continuously surging prices and compressing yields to make target returns – typically mid-teen IRRs – and this has impacted capital raisings for the traditional funds targeting the risk-return profile. The number of value-add fund vehicles to close dropped year-on-year in 2017 across all the main regions, according to PERE data. Year to date, 18 funds have attracted an aggregate $10.32 billion from investors, a proportionately precipitous fall from the strategy’s fundraising zenith in 2014 when 128 funds garnered $40.24 billion.
Still, managers running value-add fund strategies continue to launch new funds because potential remains – for those managers willing to roll up their sleeves. One of these asset managers is New York-headquartered GreenOak Real Estate, which in May closed a $1.55 billion US fund, GreenOak US Fund III, for investments in New York, Boston, Los Angeles and San Francisco – all well-recovered markets with high demand.
Co-founder Sonny Kalsi acknowledges the US real estate market, which constitutes the lion’s share of value-add investing, peaked in 2015. He points to transaction volumes down 30 percent in 2017 versus 2015, blaming a widening bid-ask gap emerging as the cycle matured.
“The big thing that is happening is that the people that should have sold in 2015 and 2016, but missed that market top, have been hoping for a market recovery for the last few years. Now they are increasingly realizing it is not going to happen, so more are going back to the market.”
But, he says: “If they have to sell, even if they are not really distressed, they still make money if they bought in 2010, 2011 or 2012 – even if the market has come down 10 or 20 percent. Sometimes it just takes a while for people to let go of their lost gains,” he says.
GreenOak has raised its fund in the belief that supply is returning in the US and managers can increasingly acquire the assets relevant for value-add strategies and Kalsi believes the raise demonstrates continual investor support. Gone is the low-hanging fruit afforded by a rising market, but there are still opportunities if you do your homework, Kalsi states.
“You have to stay ahead of the curve to find the hidden gems and then work those assets as well as the legal and financial constraints surrounding them to raise revenue. It is about creating attractive assets for investors while having control of capital expenditure, so that even if the market goes poorly, we still make money for the investors,” he says.
According to PERE data, the number of closings of North America-focused value-add funds has seen a drop to 46 in 2017 since the peak of 85 in 2013. However, the amount of raised capital increased significantly in 2017 to $20.6 billion, up 58 percent year-on-year, as investors boosted their support for fewer managers with demonstrable track records.
Last year, GreenOak sold a portfolio of 11 residential buildings in downtown San Francisco in neighborhoods that had challenges – including rent controls – to overcome. After addressing the issue and re-tenanting about 50 percent of the units at market rents, they were sold to a Canadian pension fund. Kalsi sees the case as an example of an effective investment made in 2014 in an upward market and sold in 2017 at target levels even while values were going down. This residential strategy will be continued for the newly closed US fund.
Europe just right
The outlook for opportunities is similar in Europe where GreenOak Real Estate is active in the recovering markets of Spain and Italy. The manager is also increasingly moving in to France after the departure of the previous government, which according to Kalsi made France the most underperforming major economy in Europe.
However, 2017 saw a drop of value-add funds closing and in capital raised to allocate to the European market with nine funds aggregating almost $4 billion, down from a peak in
2014, according to PERE data.
In the UK, Manish Chande, senior partner at London-based fund manager Clearbell Capital, reports of a Goldilocks economy not too hot, not too cold, but just right. Accordingly, he talks up the outlook for value-add real estate investing in the country. Specifically, he favors London’s sub-markets where shifting dynamics are creating opportunities in offices
that, before the Brexit vote, were short on supply. As many value-add investors do, Clearbell targets small to medium-sized investments, typically of less than $100 million.
“When we pick those smaller assets up, we can create an aggregator model and build up a portfolio that in volume will have a normal size but hold more units that will then be attractive to pick up by other investors,” says Manish Chande.
Among his firm’s projects is a shopping center in the university city of Durham being converted into prime leisure. The strategy includes adding a cinema with a 30-year lease and restaurants, converting carparking underneath to a bowling center, and building more than 200 student homes on top of the cinema.The latter are pre-sold to a student accommodation operator, and that has enabled Clearbell to de-risk the investment by reducing its requirement for leverage.
“To extract returns as a value-add asset manager you always need to be a sharpshooter and be willing to do the nitty-gritty work down on the ground level of developing an asset,” says Chande.
According to PERE data, 2017 saw a drop of value-add fund activity in Asia-Pacific markets from a peak in 2014. However, the amount of capital raised in closed funds had by June 10 already surpassed 2017’s total with more than $2.1 billion raised.
Nicholas Wong, principal and head of the Asia-Pacific team at Cleveland-based investment and advisory firm Townsend Group, sees “an abundance” of value-add opportunities throughout the Asian and Australian markets. His optimism stems from the diversity of the region’s different markets and their cycles.
“You have to be good at what you do and do your homework, but because there are different cycles across the region, the opportunities are there,” says Nicholas Wong.
That means constant opportunities everywhere, even where markets are supposedly tight, because there are well-located yet undermanaged assets that have potential to catch up to premium occupancy and rent levels – albeit with varying degrees of capital expenditure put into them. According to Wong, it’s possible to achieve mid-teen returns in markets like Japan and Australia, where many local markets are close to the end of their cycle, as well as China. The key is to appropriately evaluate the type of risk taken.
“You have to have the right personnel with the right skillset and track record to do value-add and the sourcing network to spot the right assets and the possibilities at hand in local markets. That is an even more pivotal prerequisite because it is a bigger task of explaining the potential to investors since the domestic markets are relatively more different in terms of legal and economic status compared to the US and even Europe,” says Wong, but adds that there are few managers in the region that possess such skill sets or performance records.
“I would be very reluctant if somebody came to us and wanted to raise a value add-fund doing Tokyo and Osaka for $3 billion. That is impossible, because there are not enough opportunities. If a fund was $300 million-$500 million, then it would be realistic. But for value-add, too large a size can be a challenge,” he says.
According to Amélie Delaunay, director – research and professional standards at ANREV, the Asian association for Investors in Non-listed Real Estate Vehicles, the headcount of managers with ambitions to throw their hat in Asia’s value-add ring is growing. The gross asset value is growing too, but is still small if compared to core strategies in Europe, for example.
“This year, investors noted that value-add was the best style in terms of risk and return performance prospect in the region. So probably the strategy will attract more investors,” says Delaunay.
Each region is at a different stage in it cycle, but there will always be work for value-add managers to do, particularly those willing and able to back their skills over the market.