Core-Plus, Value-Add and Opportunistic Investments
Call it what you will – a wall or tsunami of money, dry powder or patient capital – there is no shortage of investors seeking safety and a bit of yield. Finding quality properties though is the challenge. With turbulence and capital outflows in emerging markets on the increase, commercial real estate in the U.S. is looking ever more appealing. Cap rates in the gateway markets, (Manhattan, Boston, Washington, DC, Los Angeles, San Francisco and Chicago) have pushed below 5.0%. Pricing per square foot, per unit and per key is at near-record levels.
It is not surprising then that the competition for assets in secondary markets and alternative asset classes has heated up. As sellers cash out in gateway markets, some are redeploying capital. Investors seeking higher yields, either through income growth or capital appreciation, will have to follow suit and take a chance on more peripheral locations, buy and improve lower-grade assets or undertake lengthy development/conversion projects.
The U.S. real estate market has an abundance of assets in need of repositioning and developers looking for investors. As investors proceed deeper into secondary and tertiary markets, or into alternative assets, they run the risk of digesting too many exotic assets. Knowing which projects will be successful in the long term requires good advice and detailed local knowledge in such a varied and granular landscape.
Core plus tip: Select suburban U.S. Sunbelt Class A office buildings – Short to medium term
Core-plus is increasingly about geography and capturing the upside in secondary and tertiary markets. Buyers seeking a bit more income growth will have to look outside the top markets to “late recovery markets” in major metro areas and pursue properties in secondary locations.
More investors are following the flow of businesses and residents from costlier Northeast and Midwest markets to high-growth/low cost markets in the Southeast and Southwest and Mountain West – the “Sunbelt” markets. Migration to the Sunbelt has been the norm for several decades but was curbed during the recession. The recovery has seen resurgent flows of people and businesses eager to capitalise on the lower costs of living and doing business.
Tech firms in particular have participated in this shift. Although initially focused on major cities such as Manhattan, Chicago and Boston, they have discovered that Sunbelt metros have a lot of talent. Many Sunbelt markets have seen the emergence of particular tech specialities such as fintech in Atlanta, defense/software and chipmakers in Phoenix, biotech/biopharm in Raleigh/Durham and alternative energy in Denver. Investors will need to focus on buildings with proximity to mass transit and residential neighbourhoods. Average cap rates in these markets are 6.8% to 7.9% which compares to an average of 5.2% across all US CBDs. These markets are likely to register moderate NOI growth.
Core Plus/Value-Add tip: USA A-/B+ office product on the edge of prime, nearby discount markets and B & C buildings in supply starved locations – Short to medium term
Class A rents have hit levels in prime CBDs and some submarkets that were previously considered unattainable. As the gap in rent between top-tier buildings and A-/B+ properties widens (often to more than 20%) the prospects for incremental NOI growth in older properties improves. Some cap rate compression for A-/B+ space has already occurred but the prospects for short-term rental rate growth are still strong.
Value add options even include some of the most iconic properties such as Willis Tower in Chicago (former Sears Tower) and the Empire State Building in Manhattan. Inefficient space configurations, older building mechanicals and outdated amenities will require a lot of capital improvement and restacking of tenants.
Value-add tip: USA Class B/C-starved submarkets
TAMI (technology, advertising, media, and information) sector companies have taken over some submarkets (Midtown South in Manhattan, Cambridge in Boston, LoDo in Denver and River North in Chicago) and stripped these areas bare of Class B spare. In turn they have pushed the traditional tenant base in these districts (non-profits, architects, small business) into neighbouring areas such as Penn Plaza/Garment District in Manhattan and the Financial District in Boston.
The displacement of traditional space users has been accelerated by a rush of developers to convert older office buildings and some industrial product to creative office space, luxury condos and hotels. Pricing in TAMI-fuelled submarkets such as Santa Monica, River North and Midtown South (Manhattan) has spiralled higher, so opportunities to achieve both NOI growth and capital appreciation are in more peripheral sections such as Downtown Los Angeles, Playa Vista and El Segundo. In Orange County, California and the Peninsula (between Silicon Valley and San Francisco) very limited new construction and growing demand for larger blocks is turning buildings that were considered distressed assets a few quarters ago, into “value-add” gold mines.
Core-Plus tip: USA Secondary warehouses & distribution product – Short to medium term
As recently as a year ago the industrial sector, even at the heart of the supply chain, was still undervalued but it is now a core investment. The fundamentals underlying it are in many ways the strongest of all of the asset classes. Multiple demand drivers continue to support steady leasing in warehouse and distribution facilities. These include surging e-commerce sales and the scramble to reduce ‘click to delivery’ times, strong import activity, and household income growth resulting in rebounding housing and auto sales. The sector is the most supply-starved asset class – net absorption in warehouses totalled 141 million square feet in the first three quarters of the year, but only 130.0 m sf is currently under construction. Low supply prevails not only in logistics and distribution hubs such as Los Angeles and Miami but also secondary and tertiary markets, such as Portland, Oregon and Oklahoma City.
Investors have recently increased their focus on “final mile” logistics and third party logistics (3PL) facilities within a day of large urban centres in locations such as Northern New Jersey, Long Island and Southern California. As space in primary markets tightens further rental growth has spread out to the edge of logistics/distribution hubs. There is increasing willingness to enter secondary markets and competition for assets has intensified. Cap rates in Orange County for example average 4.6% and 5.1% in NYC boroughs but move out to over 7% in Salt Lake City and Atlanta.
Other Core-plus/Value-Add tips: Garden apartment portfolios in Sunbelt and Western markets
The multi-family market was the first asset class to gain momentum when the recovery started and it remains a favourite target of core and core-plus investors so cap rates have come in to under 5% in Boston, Manhattan, San Francisco and even Washington, DC and Los Angeles. Garden apartment buildings in Southeast and Southwest markets are priced at a fraction of the high and mid-rise product in urban areas.
Most millennials are still priced out of the housing market, so metro areas with a growing number of recent college graduates such as – Phoenix, Austin, Denver, Atlanta and Washington, DC - have a steady base of apartment dwellers. Rental growth has picked up in many of these markets, particularly in proximity to mass transit, retail and other attractions. These cities may also offer value-add options to update older apartment buildings and loft buildings, particularly in the high-demand urban core. Value-add purchase and upgrading of older garden apartment buildings constructed several cycles ago has strongest upside potential but investors need to watch out for competing supply in some markets where there can be thousands of additional units in the development pipeline.
Office and flex buildings in secondary and tertiary “tech markets” The quest for tech talent and innovation has led some big employers to secondary and tertiary markets such as Austin, Nashville, Salt Lake City and Minneapolis. Acquisitions and investments fund extensive hiring initiatives and spur strong demand for office space. They can also make a big splash in markets with a limited amount of institutional grade flex and office product.
Secondary and tertiary markets cannot offer all of the attractions of the 24-hour cities/gateway markets, but they generally have enough talent and the cool/authentic vibe that the tech and creative sector companies covet. Some are set in university towns or former “company towns” that have a high percentage of educated professionals. This includes tertiary markets such as Huntsville, Alabama as well as Knoxville, Tennessee and Albuquerque, New Mexico. Even Nashville’s music and entertainment sector has fostered entertainment startups (as well as being on a growing list of smaller cities like San Luis Obispo, California; Worcester, Massachusetts and New Haven, Connecticut that have a burgeoning health care startup scene. Cap rates for workspace in these cities are usually in excess of 7% and can be over 9%.
Under-served/outmoded retail improvements in gentrifying commercial districts and inner suburb/city edge
Retail product has not always been adequately developed alongside new residential and office development in some older commercial corridors and close-in suburbs. Older 1980s and 90s buildings could gain higher rent and foot traffic with building improvements to serve new and growing populations. There is also a gap in luxury high-end retail in “new tech” markets with increasingly affluent younger residents.
Opportunistic tips: Place-making
Part of the appeal of many cities is their unique and authentic culture but as investors from China, Canada and Europe increase their stakes in major U.S. developments, it may seem to validate the notion that the “world is flat”. However, an increasing number of people and businesses in the US are pushing against homogenisation or the “cookie-cutter/chain-store” settings often associated with suburban subdivisions and strip malls. The overwhelming mantra or catch-phrase among suburban planners and developers is creating “live/work/play settings with a sense of place.” The authenticity much prized by the millennial tech generation may be tough to build but pays dividends. Replicating the “cool and edgy” vibe of SoMa, the Meatpacking District in Manhattan or Downtown Austin and Nashville, may be impossible in suburban locations but urban amenities or the creation of a town centre, even in suburban markets, offers businesses and residents a lot of convenience, not to mention higher property values.
It doesn’t take a development the size of Hudson Yards in Manhattan to spur value-add and opportunistic buys. Renovations to industrial business parks or corporate campuses can enhance the value of properties surrounding these facilities.