Are You a CRE Value Investor?

Value investing is typically associated with successful stock and bond investors like Warren Buffett and Charlie Munger of Berkshire Hathaway, Seth Klarman of Baupost, Chris Browne of Tweedy Browne, Ben Graham, the Godfather of value investing and mentor to Warren Buffett, Peter Lynch of Fidelity and Bill Ruane of Sequoia Fund. Value investors seek to buy common stocks at discounts to the intrinsic value of at least 50%-60% and use rigorous fundamental analysis to discover these discounted gems. Value investing is a very difficult business because, when the stock market is richly valued, it’s hard to find big discounts and these investors don’t follow the herd on Wall Street and the institutional investor mentality. They have to take contrarian investment positions, and this can be problematic in a rising stock market. In many cases, the value stocks they buy at a discounted value must be held for years for the true intrinsic value to be realized.

Two of the best books on value investing was written by Seth Klarman, Founder and Principal of The Baupost Group titled, “Margin of Safety” and Tren Griffin, a former private equity investor titled, “Charlie Munger, the Complete Investor”. The Margin of Safety book has some great comments on Wall Street. The books say that; “Wall Street works against investors because they make their money on transaction volume, upfront fees, underwritings over secondary market transactions and they have a short-term, bullish biased focus and not on doing good deals. The Munger book also has some great comments on company moats. A moat is a company’s competitive advantage to protect its market share and profits and most value investors seek companies that have one or more moats. There are five types of corporate moats that include; supply-side economies of scale and scope (low-cost producers), demand-side economies of scale (network effects), a brand or franchise, regulation protection and patents and intellectual property. Many of these same value investing attributes can be applied to the CRE industry.

The value investing philosophy can be applied to CRE properties to generate higher alpha type returns. There are numerous successful companies applying this strategy in the industry today including developers, private equity investors, and institutional investors. These investors seek to acquire good real estate and at a great value, look for value-added and opportunistic deals, seek to acquire and renovate Class C apartments and convert to higher rental Class B properties or seek to invest in distressed retail and office projects with high vacancies and physical deficiencies. There are also moats in CRE investing. These moats include; a great location wherein there is no land for competing properties, long-term leases with high credit tenants, development project with full entitlements and a specialized or architecturally significant and designed property.

The CRE industry today is very competitive and it is difficult to acquire discounted assets other than in certain distressed periods or situations. Additionally, low-interest rates have resulted in a lot of capital chasing deals. A large portion of the returns made in the last several years was the result of cap rate compression and the low cost of capital and not on value-added or opportunistic strategies. The riskiest time to buy commercial real estate is when the economy is strong and interest rates are low as is the case today. An environment of cheap capital pushes up assets prices and reduces current returns. Investors who buy today are playing the futures market by wagering that they will be able to sell the property at the same cap rate and credit market, even though the risk for higher rates and tighter credit are much greater. A booming real estate market as with a strong stock market is difficult for the value investor as there are fewer discounted deals, turnaround opportunities and properties with moats.

Successful CRE value investing can provide higher returns, but sponsors must undertake contrarian strategies that include construction, redevelopment, retenanting, lease-up strategies, entitlement completion, refinancing, tenant and interest rate risks. A key component of a successful value investment CRE strategy usually includes a construction or redevelopment component and the investor must have a solid in-house expertise or working relationship with experienced contractors to complete full or partial property renovations on time and within the cost budget. Most valued added investment strategies in CRE include this redevelopment component and therefore this is critical to creating value. Most institutional investors do not have or do not want to “get their hands dirty” in a redevelopment deal and usually do not consider this type of CRE investment strategy.

CRE value investing typically includes the following strategies:

• Major or minor redevelopment of the property.
• Substantial renovation of apartment units or commercial space.
• Retenanting or repositioning a high vacancy property.
• Demolishing and rebuilding a property in which there is a higher and better use for the site.
• Expanding a property with additional units or rentable square feet
• Converting a property to a different use, i.e., office to hotel, office to hi-rise apartments, retail center to office service or office to data center.
• New management program and operational strategy that can increase current rents and occupancy.
• Developing new sources of revenue, i.e., bill tenants for water, trash and sewer, RUBS submetering program for apartments and converting commercial leases to triple net from gross or double net.
• Investing in areas or markets that are out of favor or heavily distressed, i.e., the City of Detroit and the Central Valley of California.
• Leasing the property to high credit tenants under long-term leases.
• Obtaining full entitlements for a large mixed-use development.

There are three central elements in a value investment philosophy, as detailed in the Margin of Safety book, that also applies to CRE value investors as follows:

It is a bottoms-up strategy requiring analysis of the real estate asset first, then the local market, the metropolitan statistical area (MSA), national market and finally the economy.

Value investing requires absolute performance, not relative performance. CRE value investors seek to earn higher risk-adjusted returns as compared with their own investment goals, not the returns on various indexes like NCREIF, FTSE Equity REIT Index, etc.

CRE value investing is also a risk adverse approach that requires the sponsor to evaluate not only the potential return but the risk of not achieving that return or losing all or a portion of the equity investment.

CRE value investing is a niche strategy that requires patient capital, expertise in construction and renovation and the ability to see value where others see detriment. If CRE value investing strategies are applied successfully, they can generate significant alpha returns in this competitive real estate environment.

Joseph Ori is executive managing director of Paramount Capital Corp. The views expressed here are the author’s own and not that of ALM’s Real Estate Media Group.