Protecting Investors as Steward of Capital

As an emerging investment manager going into Q1 2020, we were in the process of building and scaling our assets under management or “AUM” with our next investment. This was a very unique event-driven opportunity where we had the opportunity to pre-lease a large vacant building to a blue chip office tenant in conjunction with buying it.

We opted not to move forward with a $95M acquisition/redevelopment that was scheduled to close in April 2020. This protected our investors from a steep, near-term decline in value despite having worked on this project for over 6 months and having incurred over $200,000 in pursuit costs.

As stewards of capital to our investors, and with complete respect and transparency to the Seller and their broker’s need to preserve the property value, hitting the pause button and stepping aside was the right thing to do…as painful as it was.

As fiduciaries to our investors, it boils down to protecting and preserving investors at all costs, even if that means it comes out of your own pocket as the sponsor.

COVID has Accelerated the Rationalization of Space Use

The pandemic has triggered a broad rationalization of how space is used for each property type. This is going to be a slow iterative process, not a quick solution. However, there are trends and ways to create flexibility within spaces to service this process of rationalization.

Since Amazon purchased Whole Foods in 2017, retail has been evolving to complement online purchase activity as well as the demand for experiential spaces leading up to 2020. As a result of the pandemic, retail’s evolution has been put through the equivalent of a meat grinder such as the number of space tenants require, their uses of the space, lease structure, and the necessary alignment with the retailer’s business model. There is still too much mall retail space that is ripe for conversion to housing.

Office space has been accelerated too. The question remains, what is the net demand for office space and how is that space going to be laid out? We believe the ultimate answer is “omniwork” created through a hub and spoke model, where employees have the flexibility to work from anywhere as well as coming into the office. This provides flexibility to employers to accommodate individual employee migration patterns driven by affordability and taxes, COVID prevention preferences and household formation. This will have different implications for different-sized businesses that require different footprints of space.

Resetting Landlord-Tenant Dynamics to Lease Commercial Space During COVID

Landlords and prospective office and retail tenants are advised to explore ways to reset and help each other grow over the next 1-2 year recovery. This will involve both parties to become “experimentation partners” to determine what works and what doesn’t work, toward achieving a stabilized rent payment stream.

Here are three ways landlords can adjust their offerings to partner with tenants to get through COVID recovery:

  1. New commercial leases can be structured to set the first 1-2 years at a COVID recovery rent rate. At the end of this period, both parties will have the opportunity to revisit and reset the rent to the market rent rate to continue operating with flexible timing and payment structure.
  2. Landlords can offer tenants temporary use of additional vacant and/or amenity spaces in the building to create additional spacing for their employees and patrons.
  3. Landlords can offer online “digitally native” retail tenants with hybrid flex office-retail space to run their online business and experiment with physical retail space starting with short-term pop-up retail to establish brand awareness and ultimately sales.

Structuring the alignment of interests and seeing the current problems from side is the key. It’s a different conversation now with your tenants and you actually have to partner with them in more ways than you would have ever thought.

BrandView.AM assists investors and lenders of commercial mixed-use properties to structure and execute these strategies through our asset management services. Feel free to contact us if we can be of assistance.

Our Approach to Investing in Dislocation Opportunities (Part 3)

Event-Driven Distressed & Special Situations: We sometimes find opportunities driven by events that enable us to see more value and/or factor other discounts into the price of a property. This can happen when a seller or its lender needs to sell a property quickly at a market-clearing price due to extenuating circumstances such as financial distress. Alternatively, a special situation could result if we can align with a tenant to lease a property in advance of buying it.

Further, in special situations, we also look to structure joint ventures with property owners to bring the necessary capital and execution services to both preserve and create additional value. We also joint venture with institutional investment funds on larger $30M+ projects that are “event-driven”.

Our Approach to Investing in Dislocation Opportunities (Part 2)

Alongside Market Dislocations, another form of dislocation we like to invest in are Property Dislocations. This is when we can identify risk mis-pricing or uncover hidden value at the property level that is not apparent to the market, competing buyers and the seller. We also look for dislocations by unlocking embedded value through repositioning, repurposing spaces, adding square footage and land re-entitlement.

For example, a cash flowing apartment property with a vacant ground-floor commercial space can lead to an attractive price after factoring the added risk (or discount). How do we get comfortable with the additional commercial risk for this opportunity to be attractive? First, we evaluate the commercial space, as-is, to determine how we can release it with the least amount of cost and risk. This involves looking at any necessary renovation costs, tenant improvements/concessions, leasing commissions and downtime to lease it as retail, office or both. We can then look at both the design and permitting feasibility of repurposing the space to alternative uses such as live-work housing, medical office etc should they yield higher income yield in relation to the additional cost and risk.

The more ways you can feasibly reposition a space, the less risk there is associated with it, assuming the cost is factored into the price. If we can do so feasibly at an acceptable price to the seller, then we have found value potential invisible to others, which is our mantra at BrandView.

Our Approach to Investing in Dislocation Opportunities

We focus on small to medium-sized value-add multifamily and commercial mixed-use projects between $2-30 million dollars through our Fund I and syndication vehicles.

Market Dislocations – We look for mispricing of risk in opportunities across (i) regional markets in Southern CA and (ii) property types and (iii) neighborhood micro-markets. This is amplified by focusing on fragmented small balance “mom & pop“ and middle-market deal size.

For example, the urban exodus is one example of a potential market dislocation that could lead to mispriced assets that could enable purchase and delivery of more affordable housing.

Finding Higher Risk-Adjusted Returns: Why We Invest in Dislocations

Our investment strategy is focused on capitalizing “dislocation” opportunities. What are they?

Market dislocations are circumstances in which markets, operating under stressful conditions, cease to price assets correctly on an absolute and relative basis. Translated, this means assets perceived to be “higher risk” are priced lower because both equity investors and mortgage lenders require higher rates of return on their respective capital for this higher risk. Property types going through the most dislocation as a result of the COVID pandemic are hotels, retail and office.

For example, as a result of COVID, there is currently a negative perception of office and retail assets as being increasingly risky versus stronger performing apartment and industrial assets that can present market dislocation opportunities. There could easily be less risky retail and office investments with strong tenancy that could get priced lower (at higher returns) due to this macro perception of risk. This creates a great arbitrage opportunity.

We love when we see lower risk in a given property than what the market is pricing because we achieve higher returns in exchange for the lower risk. This is called an asymmetric risk-return relationship in which the returns outweigh the risks, or the upside is greater than the downside.

Our ability to price this risk differently is driven by our mixed-use capabilities in looking at property value in multiple ways. It is further driven by a focus on local SoCal markets where we have been operating the past 6 years, in addition to 10 years in my prior corporate role.

We will go further into the type of dislocations we invest in the next post. Feel free to reach out if you would like to learn more about our investment fund strategy.

Our Value Investment Pro forma Approach

The Yield-on-Total Cost approach factors in all of the feasibility, cost and risk that need to be considered on a project where you’re looking to add value. This is based on a simple formula:

Total Yield or Annual Net Operating Income (=Rent-Vacancy-Operating Expenses)

Divided by Total Project Cost (=Purchase Price+ Carry Cost during vacancy + Construction/Leasing/Permitting costs)

= Target Yield on Total Cost

A vacant transitional building can’t be sold for a cap rate, but it can be evaluated using the Yield-on-Total Cost

When you’re buying transitional buildings you’re buying opportunities, such as land, to create value. In this situation, you are solving your property value or purchase price based on all of the costs, time and risk to arrive at what would be the stabilized income on that building – to arrive at your cap rate.

To set your required Yield on Total Cost, you need to have taken into account all of the risk, effort and costs based on a full business plan with all of the feasibilities calculated, to know how much you need to make a profit. It may be that you need a 6% cap rate, because you can then go and sell it to the market at a 5% cap rate, a lower rate on the same cash flow, which gives you profit.

Pro forma Valuation Approaches

To go back to our first principles, we’ve got three components: time value money, opportunity cost and risk. Those are all in our desired discount rate of return which is then applied to the series of cash flows which reflects the design, permitting the cost: the debt and the equity. In order to evaluate what it is and to come up with a value, a sub component of that is the risk, which comes back to design.

Can you design this thing? Can you build it? Well you can build anything you want if you can get a permit for it… but will there be a market to lease it to? If you’re building a vacant office building, will there be tenants? Everyone is price motivated, so what would be the rents that you would have to achieve in order for this to be attractive to tenants and to also generate a return to you on the purchase value, plus the cost, plus the discount rate on the future? In other words, what are the total costs so you can calculate how to generate a profit.

You are doing market feasibility, design permit feasibility, costs and financing feasibility to assess the risk component of the rate of return. To use an example, let’s say that you’re buying a piece of land that’s been completely permitted and designed for a building that is very much in need for that market. This would be a hundred units of apartments in an area that is lacking housing. The land is right across the street from a large tech firm who have a young employee base.

A lot of money goes into designing and building and it’s already been approved. So that removes a lot of uncertainty. Well, what does that do to your discount rate or required return? Would that bring it down or up versus buying some raw land and having to start from scratch? A reduction in uncertainty would bring down your rate of return, because from the lower risk, you don’t need as much return. It’s very much in demand, and so you could pay more for that building and land and accept a lower rate of return because it’s more design-feasible, permit-feasible and you only have to address your construction costs in the rate of return. So every time you’re building up your rate of return, this equates to risk, where risk can be broken down by market, financial cost, design and permitting pieces.

Read next…”Our Value Investment Pro forma Approach”

How Two People Can See a Property Differently

Would a hungry entrepreneurial real estate investor that really needs to gain traction with investors look at a 5% cap rate as attractively as a very wealthy established owner with a lot of real estate?

The established owner is going to look at 5% from their vantage point of wanting to preserve risk. Is this a low enough chance of risk to feel comfortable that they are not going to lose money? In their situation, they do not need to make a lot of money. They will take a lower risk. On the other hand, the hungry investor may be on the look-out for something a little less comfortable that may create an 8% return of their investors who are seeking higher returns. For this investor, the 5% is not enough.

To share another example, a property may be the only property not owned by a sole owner who owns all of the other buildings on the street. To the owner, a 5% cap rate may sound really cheap! They may take a 2% capital rate of return because they could average it with all their other buildings as they now own the whole street. This investor might even pay $20 million instead of $10 million to take on the 2%.

This is how markets are established. You have groups of buyers establishing the what, the why and to whom. When a decision to sell a property is made, the property may be sold at market value or the sellers may choose to wait until the right buyer comes along who pays above market price, because to them, it’s a good deal.

At BrandView, we specialize in weighing up all of these factors to find what is a good margin for our investors. The financial analysis of a property may state that the cap rate has a 5% return. Well, is there a path that could be taken to create a 10% return? How much risk and execution is in that path and what do you have to believe in to achieve it? We’re always trying to create new avenues and extensively look at different deals and all of the associated paths for creating value on a property.

Components of Value

Value is based on your discount rate. A component of your discount rate of return is the risk and the way to assess the risk of a property is really three things: permitting, design and market. Is there a market for what this building is trying to do? From there, are the associated costs with the design and permitting feasible? And lastly, is the financing feasible, which means is there a source of debt and/or equity for this type of bill?

Read next…”Pro forma Valuation Approaches”