Real estate transactions are complex, and it’s imperative an investor understands the nuances that lead to a successful project. This article will discuss two common asset classifications, stabilized and value add, and how to compare the two by looking at capitalization rates, debt options, and the risk and return potential of each. While there are many factors that must be analyzed when purchasing real estate, understanding these three will give an investor a fundamental knowledge base.
Between stabilized and value add assets, the capitalization (cap) rate will potentially vary significantly. Stabilized assets will usually have a higher in-place cap rate, implying more income day one. Value add purchases will have lower cap rates at purchase, and thus lower in-place income.
Cap rates vary based on a multitude of factors, including asset quality, stability of revenue sources, location and asset type. Stabilized assets will see cap rates that are representative of the market and risk profile of the asset. These assets are fully leased and at market rental rates. The assumption is the cap rate, and thus the income, will not change much during the hold period.
Investors in stabilized assets generally expect the return to not fluctuate, providing consistent income but with limited upside potential. The income at purchase is assumed to be consistent over the hold period.
On value-add purchases, the existing cap rate is one of many factors influencing the valuation. Understanding there is still the ability to increase income, value-add properties are priced at lower cap rates.
There is often a delta between the existing cap rate and the future cap rate once the property has stabilized. This difference represents the value to be created by the investor through leasing up vacancies and/or increasing rental rates. The spread between existing cap rates on value-add projects and the “stabilized” cap rate will be between 100-300 basis points but can be significantly more depending on the situation.
Lending options differ based on the underlying fundamentals and profile of the asset. As many investors will purchase an asset with some amount of debt, understanding the options is an important factor to consider.
Most lenders prefer stabilized assets because they are perceived as less risky, so an investor in these assets will have more optionality. The property has steady in-place cash flow that lenders can reasonably underwrite, and a history of strong performance. Due to this benefit, borrowers looking at stabilized purchases will often receive more advantageous loans, including lower interest rates, 55% to 70% Loan to Value (LTV), and traditionally a 10-year term of the debt.
Value-add purchases encompass more risk, and borrowers may have fewer options. The asset likely does not have a consistent income stream. As discussed above, the cap rate is lower upon purchase. To compensate for this risk, lenders will expect a higher interest rate on the loan. These loans have a shorter duration, with loan terms between three and six years. Historically lenders will be able to increase the LTV because the property has not achieved its highest value, and borrowers can expect LTVs between 60% to 80%. Understanding the cash flow is lower initially, some lenders may even grant six to eighteen months of interest-only payments, lowering the borrower’s debt obligations as they are working on improving the property and increasing cash flow.
In any asset purchase, there is risk involved, regardless of whether the asset is stabilized or value-add. Stabilized assets have risks of macro market changes, such as declining rental rates and property market values shrinking. If this happens and with fewer options for the owner to create additional value, the same asset is no longer as valuable as it once was. Alternatively, value-add assets are inherently risky as well. With lower in-place income on value-add assets, existing margins for error are significantly less. An investor must adequately execute their business plan, or else the asset will produce a substantially lower return than expected.
The loss of significant revenue, such as one major tenant leaving, may cause the asset to not be able to sufficiently cover the debt costs. This situation puts the asset and owner at risk of foreclosure. Stabilized property investors are looking for consistency. There is in-place cash flow to provide sufficient debt coverage, while also distributing predictable returns to the investor. For these investors, the stability of returns outweighs the upside potential that may be sacrificed. Conversely, value-add purchases allow an investor to potentially realize a greater return relative to stabilized assets of similar quality, but there is an execution risk to get the property to that point.
On a risk-adjusted basis, purchasing stabilized or value-add assets can be extremely successful. The important fundamental is understanding exactly which profile of asset you are investing in and developing a strong business plan around the asset. By understanding the different cap rates being purchased, debt options, and the risk and return profile of each, an investor can put themselves in a position for long-term wealth creation.
Bio:
Tyler Burke is the SVP of Acquisitions at Spartan Investment Group where he focuses primarily on acquisitions and business development. He is responsible for leading the acquisition process across multiple markets.
Before Spartan, Tyler worked for one of the largest private equity owners of neighborhood retail shopping centers. He graduated from Colorado State University with a bachelor’s degree in Economics.
