Transparency in REPE — Letter #2 Industrial value-add explained
In letter #2 of our series Transparency in REPE we delve into explaining what exactly constitutes an industrial value-add real estate investment.
Industrial value-add investment explained.
Across the spectrum of asset types value-add investing is best described as the search for asset anomalies and or market inefficiencies to earn risk adjusted returns. And really it is just that simple, but then how much fun would it be if finding value-add investments was really just that simple. After a brief description of other investment methodologies we will dive into industrial value add investments.
In the stodgy world of institutional real estate acquires seek investments that carry reduced risk with yields measured in basis points above their cost to borrow. The investments are atypically high quality assets referred to as core or core+ investments. Tenants in these properties are very good credit companies. The institutional investor is willing to pay a higher price with lower returns for these high quality assets.
In contrast to the institutional investor enter the wild wild west universe of value-add investing. Investors in this universe seek yields considerably higher than that of the institutional investor, hence the term “risk adjusted”. The entire value-add process is designed to increase the net operating income of the property thereby increasing its market value.
The value-add investor has been known to ride solo spurs ground sharp or bring along a posse with instructions to take no prisoners. S/he is organized in a way to pounce on opportunities as they appear on the horizon. With aviators adorned what exactly are they looking for across the value-add horizon?
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A value-add investment on the industrial ponderosa will fall into one of these three primary categories. A physical abnormality, functional obsolescence, or an ownership structural incongruity. How do these play out in the wild wild west? Lets take a quick look at some examples of industrial value-add:
- Requires physical improvement.
- Construction of a new building on excess land.
- Leasing vacant building or units.
- Tenants paying under market rents ratchet up to market rate rents.
- Cure of debt, title, or environmental issues.
- Resolution of partner (divorce) or partnership disputes between parties of the seller.
When a value-add property has been identified there will be a shootout for the asset unless the investor was able to sneak up alone on the seller. These opportunities can become quite competitive. Once acquired the asset manager alongside the property manager will manage the corrective value-add measures to completion.
The asset manager will then move the investment to the next phase and work to get the asset stabilized.
The investment methodology of the investor will determine the value recognition phase. If the investor plans to exit the investment then the asset manager will place the property on the market for sale. Conversely, if the investor is a tax efficient perpetual hold investor the property can be refinanced.
As a matter of record our firm Terra Melius Capital, in most cases, is a perpetual hold investor. In the value recognition phase of the hypothetical example above TMCapital would move to refinance the property using a conservative level of debt and return capital to limited partners. With this distribution and within a short period of time thereafter the LPs would receive the return of their entire investment retaining the same degree of property ownership and a perpetual infinite cash flow return thereafter.
As Hoss might say, ‘why, it could be fun to hitch your horse to our wagon and haul it on down to the bank’.
Christopher Telles is Managing Partner of Terra Melius Capital a real estate private equity company acquiring value-add industrial in Southern California and Phoenix, and hospitality nationwide. You can reach him on his twitter handle @tellesio or by email: chris@terramelius.io
