Passive investors are running far, far away from heavy value-add deals. Don’t get me wrong, over the last decade the “heavy” value-add strategy has provided fantastic returns to passive investors, so what’s changed?
Big lift opportunities inherently have more risk than lighter “lipstick” value add opportunities. They require substantial capital budgets, hold higher and longer rates of vacancy as renovations are underway and take time to market to a new demographic of tenants because the majority of the old tenant base can no longer afford the rents of renovated units.
As a result of these additional challenges relative to more stabilized properties, operators are having to over capitalize these projects so they can fund carrying costs while they implement the massive overhauls until the property stabilizes. As we discussed in our last article, as interest rates rise so do the monthly mortgage payments and the risk to investors looking to shield their wealth. This creates the perfect storm because when the operator cannot execute these massive undertakings as planned due to the new challenges like supply chain and labor constraints, the operator will call upon investors for more capital further reducing returns or alternatively won’t be able to make the mortgage payment, resulting in the loss of all of their investors capital as the property gets foreclosed on by the bank.
When we compare these opportunities' returns and the challenges they are facing relative to less intensive value add properties, we find they have similar returns (12-16%), and do not present the same level of risk and exposure to passive investors, making them a clear choice when looking to place their hard earned capital.