Market Updates & Insights

Navigating Private Commercial Real Estate Investments: Development Vs. Value-Add

June 04, 2024

Private commercial real estate (CRE) investing continues to gain popularity due to its return profile, lower volatility and the need for increased yield in investment portfolios.

Sophisticated investors aiming for elevated returns may find CRE investing more attractive than traditional public market investments in real estate that come with increased volatility. Within CRE investing, two prominent strategies are prevalent to achieve increased returns for investors: development and value-add. Each approach offers distinct advantages and challenges for debt and equity investments, catering to different investor preferences and market conditions. These two strategies have intricacies that must be explored to understand how they shape the investment landscape, generate returns and fit into investor portfolios.

Development: Building from the Ground Up

There would be no new buildings today without investors (in some form) providing capital through equity or debt financing for ground-up development. These projects typically offer the highest returns in the real estate sector, reflecting the additional factors and risks these projects carry. Generally, developers are most successful in markets with favourable business fundamentals, including a diversified employment base and increasing population growth, helping to drive rental rates and absorption of lots, apartments, self-storage units, or whatever is being built.  

These fundamentals are the primary driver for Trez Capital’s thesis of investing in high-growth areas with a strong job market that will drive unit absorption and rental rates at the asset level to ultimately increase the asset’s market value. This approach is more accretive to investors with a new asset versus an existing asset, as the lease-up is not dependent on existing tenant rolls and legacy issues. Leases are consistently completed at market terms and, when located in key high-growth cities, continue to drive both the income stream and valuation of the asset. New development projects offer the advantage of incorporating modern materials, newer construction methods and amenities tailored to current market demands. For instance, a new multi-family development may feature more tenant amenities than older products (i.e. gym, pool, dog park, etc.) and offer spacious units with enhanced finishes such as high ceilings, luxurious bathrooms and upscale common areas, which command premium rents and drive capital values.

Recognizing the inherent risks involved in constructing new buildings, development projects generally garner more attractive returns than stabilized property returns. However, success hinges on the manager’s expertise in navigating entitlement, construction, financing and marketing processes to finish the asset and generate cash flows for investors or stabilized value on exit.

For example, construction financing is mainly based on the loan-to-cost (LTC) metric, which compares the financing proceeds for a CRE project to its overall construction cost. The initial condition for construction financing is for the borrower to inject their equity requirement first, typically comprising 25-35% of total project costs, including land costs. The initial equity injection usually allows developers to navigate through the beginning stages of construction and reduce the project’s entitlement and site work risk, as this is the highest risk point within a construction project.

However, unknown factors such as soft spots in soil conditions, development scope changes (finishes, amenities, etc.), material pricing and labour increases (if not covered by fixed priced contracts) can lead to cost overruns and delays.

To mitigate these risks, experienced investment managers often employ rigorous risk management and asset management practices, including continuous monitoring of the underlying business plan of borrowers and stress testing to evaluate the resilience of the projects under adverse market conditions, helping to identify potential vulnerabilities and implement proactive measures to safeguard investor capital.

Furthermore, the construction loan is only fully funded upon project completion when construction is finished and the lease-up stage has already commenced, further reducing the investment risk. Investing in growth markets with strong fundamentals exhibiting upward pressure on rental rates and tight unit absorption minimizes the investment risk as the liability of lease-up and stabilization is deemed lower compared to other markets. There is limited risk of default at this stage and an increased probability of repayment on the construction loan.

Despite potential challenges, construction projects offer distinctive opportunities for investors. With the ability to drive rents and achieve market premiums, new construction projects can capitalize on emerging market trends and cater to evolving consumer preferences. Additionally, strategic allocation of equity ensures that developers have sufficient financial resources to navigate through various stages of construction, from securing entitlements to completing vertical construction.

Value-Add: Enhancing Existing Assets

Value-add strategies focus on revitalizing existing properties to unlock their full potential. These assets, often acquired at a favourable cost basis, undergo a series of renovations and repositioning efforts to enhance their economic viability and appeal.

Value-add financing differs from construction financing because it leverages existing assets with existing income. This means that critical elements like ceiling height and unit size are fixed, so the modern needs of renters may only sometimes be reflected in the end design. This approach, however, allows investment managers to deploy capital more efficiently, with funding allocated towards strategic improvements and renovations, including the addition of new tenant amenities and renovation of old units and common spaces.

One notable advantage of value-add investments is that investors can achieve attractive risk-adjusted returns by capitalizing on unique market opportunities and executing value-enhancement programs. However, this comes with the caveat of increased volatility in the short term, as returns largely depend on market movements and the successful execution of the project. The downside risk is often offset by the current income in place, which differs from construction projects that have zero income until lease-up and occupancy. The renovation program usually impacts vacant units and, once the work is completed, returns to the market with a premium over the previous rent, driving value forward and achieving risk-adjusted returns.

Value-add investments also have some associated risks, including market volatility and execution risk. For example, during a home renovation, once ceilings and walls are opened, unforeseen issues could be uncovered. To mitigate these risks, investment managers must employ rigorous due diligence and strategic asset management practices, ensuring their investments align with their long-term objectives and risk tolerance.

Strategic Considerations and Risk Management

When navigating private CRE investments, both development and value-add strategies must thoroughly consider market dynamics and effective risk management practices. For both project types, the sponsorship group, market analysis on rental rates and absorption, and capital inflows into the specific market are the most important indicators for success – investment expertise, strong initial underwriting around sponsorship and local market experience contribute to safeguarding these investments.

A development project’s three largest risk factors are rising construction costs, income stagnation during the project and uncertainty in the timeline. An important risk management tool negotiated by Trez Capital is fixed-priced contracts, which hold developers accountable for uncontrollable cost overruns instead of taking on that risk. By understanding the inherent risks, investment managers can strategically allocate resources and manage return on capital expectations. Implementing conservative timelines, leveraging strong relationships with trades and suppliers, and maintaining a skilled on-site team are essential tactics in mitigating risks associated with delays and market fluctuations.

For value-add projects, the current income already in place further de-risks the project. This income reduces the equity, and the return drag versus a vacant property and can offset the costs of the renovation program. Both investments necessitate proactive risk management measures, including comprehensive due diligence underwriting and strategic asset management. By monitoring market movements, investors can mitigate risks and capitalize on emerging private real estate market opportunities.

At Trez Capital, we are strongly focused on the asset and the business plan for both the development and value-add strategies. Our team understands the critical nature of each phase and employs a hands-on approach to ensure project milestones are met efficiently. Our commitment to excellence and thorough understanding of market dynamics allows us to navigate the complexities of CRE investments with confidence.

Investing with Trez Capital

Trez Capital has a proven track record in North American commercial real estate investments, which relies on our repeatable process and robust risk management strategies. Our investment process involves meticulous risk assessment and mitigation at every stage, with ongoing monitoring by our in-house teams and continuous communication with borrowers and developers. Our approach focuses on providing flexible equity and debt financing solutions tailored to each project’s unique needs. We focus on structuring equity and debt financings to mitigate project-specific risks.

By investing in Trez Capital’s funds, investors can customize their risk-reward preferences, knowing they are investing with an industry leader known for operational and financial excellence. Through our extensive experience and industry expertise, we help investors navigate through the complexities of commercial real estate investments and achieve superior risk-adjusted returns.

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