By Elizabeth Szep on September 18th, 2017
(Updates to correct chart axis labels.)
Record-low cap rates in the U.S. are making it harder for investors to hit their required rates of return. This challenge has pushed some investors up the risk spectrum towards a value-add strategy. But in the current market, where some assets are priced so competitively that the difference between the best and worst properties is substantially narrowed, can value-add opportunities still be found?
Our conclusions suggest that while it may be too late for value-add in the apartment market, opportunities still exist among other property types.
In a value-add play, investors purchase properties that need improvement or a lease-up on the cheap, they put in repairs or tenants, then sell the property as a stabilized asset at a higher price. One can therefore represent potential value-add gains by comparing prices on the high-end of the market to prices on the low. The difference between these extremes is not a perfect representation of return since it doesn’t take leverage or capital expenditure into account, but it acts as a simple gauge of price return for flips.
In the chart above, the long-term percent difference between the low-end and high-end price¹ of the market is plotted on the x-axis, and the difference for the last year is shown on the y-axis. Markets below the long-term line have current spreads which are narrower than in the past. Markets above the line are better opportunities for value-add. A move up the line implies greater return, and therefore greater risk.
It’s no news that apartments are highly priced. This analysis displays the low value-add returns of apartments as compared to other property types. Apartment spreads in the 6 Major Metros (6MM) and Non-Major Metros (NMM) are compressed below their long-term averages, though a better return can be found in the non-major markets.
Industrial properties in both major and non-major locales sit right above the long-term line and therefore there are still opportunities for value-add. With less risk than retail and some office types, industrial has been an investor favorite since 2015 and is the only property type posting increases in deal activity for the first half of 2017. As the industrial market becomes more saturated, price spreads are likely to narrow. So for industrial the time for value-add is now.
Among office types, deals can be found in suburban areas surrounding major markets and in the central business districts (CBD) locations of non-major markets. Since 2016, steepening office prices in major market CBDs have pushed investors outward to find returns.
Retail offers the best value-add return next to non-major CBD offices by this analysis, and prices in non-major locales still offer better gains than historic averages. In a way, this makes sense. Retail pricing has been shaky in the past year and with all the negative news on the sector’s struggles, retail bargains are ripe to be found. If an investor is savvy enough – and can stomach the risk – flipping these properties could offer high returns.
Options for value-add can still be found among several core types across markets. Though the window for apartments has closed, industrial and certain office and retail properties still offer opportunities. As always, these options boil down to trade-offs on the risk/return spectrum, and the best value-add strategy for each investor group will mostly depend on their preferences and expertise. As the saying goes: better the risk you know.
¹Percent difference between the top 95th (high-end) and bottom 5th (low-end) percentile Price Per Unit (PPU) in each market