When Leverage Does More Harm Than Good

We are increasingly looking at value property investments on an all-cash or very low loan-to-value basis in focusing on small to medium sized value-add apartment and commercial properties in the $2-25M million range.

The mortgage rates in this size range are automatically higher because it is less cost-efficient/effective for mortgage lenders to make these loans because they take the same amount of work and cost. Further, in the case of apartments, the lowest rate loans are determined based on in-place cash flow when a property is stabilized.

But what loan options are there for value-add properties with little to no income in place? The only loan options here are very high rate bridges that put a time clock on completing the value-add plan. This effectively adds risk and costs to your plan during a time period when execution is a lot uncertain.

The opportunity today is to assemble a nimble, but strong, pool of capital to target near-term property dislocation and rates environment and sell/refinance into medium-term strength. If you can capitalize near-term dislocations and refinance them into medium-term strength, it behooves capital to stay in and ride compounded rent appreciation over the long-term horizon (5-10 years+).

Value-Add Deals in LA are Pricing in More Risk

We’re currently seeing lower returns for value-add opportunities, where we would be needing to take more risk, in comparison to higher returns for stabilized properties. This is due to there being so much demand for creating value in apartments in Los Angeles.

Properties are getting priced to lower returns than finished, fully occupied and fully leased properties are. We just came across this in securing a high value-add property next door to a brand new property. Both of them were up for sale. We did the financial analysis for both and concluded that the completed, stabilized property had a higher return at a lower risk, compared to the value-add property.

By the time you would have spent all of the money on renovation costs, the value-add property became the same price as the brand new building next door, which is already generating a higher return, for lower risk.

This is the dislocation right now in LA apartment investing.

Advantages of Private vs Institutional Investing in Real Estate

One of the value propositions to private investors who we work with is that we’ve worked with institutional investors. We have the experience and processes to work on large-scale projects to bring into small-scale projects.

Everything from acting as a fiduciary, running efficient management, doing very-high level accounting, strategic asset and property management and leasing. Everything is driven by value-creation, but brought down to a smaller and medium-sized scale for private investors.

Tax implications – Institutional investors are usually tax-free because they are pension funds and don’t get taxed. Private investors do have tax implications and so what we push forward is what we call ‘Risk-Adjusted Returns After Tax’ (RAAT). Meaning we are not only delivering high property investment returns but we are also able to take advantage of the different tax strategies that are specifically available for real estate including: costs aggregation, depreciation, as well as bonus depreciation, opportunity zone investing and cash-out re-financing.

Alignment – The reason why I like to invest with private investors is the ability to have more alignment to do more for the investor, more for the asset, and more for the community. With a pension fund managed by another entity, an investor receives their return on investment in their e-trade account. I like to be able to provide the flow of energy in the form of sending the investor their return on their investment, visibly as a cheque in the mail.

Flexibility – You can also structure more flexibility with private investors to align on the property business plan. This allows you to add value in multiple phases and to hold the property longer. In comparison, with institutional investors you are typically stuck to a 3-5 year business plan. They need to get in and out. This leaves a lot of meat on the bone in terms of what you can do to the property, as well as leaving the community hanging a lot of times.

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.

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.

Starting BrandView Inc: A Mission to Find Congruence

I launched BrandView Inc in 2014 with a simple mandate: Focus on value-add investments in the sub-institutional, “small to middle market $2-50M range”, and, advise mixed-use development projects on feasibility, venture structuring, capital raising and execution. This leveraged my prior corporate experience leading these efforts for a large-scale investment/development firm. However, I had not yet identified enough purpose in it to feel consistently passionate. This was in mid-2014 when I landed a few consulting clients (including my old firm, LOWE) while developing a small residential project in La Jolla and finishing a apartment renovation in Los Angeles. I was scattered going from project-to-project and lacked a cohesive mission.

“When driven by purpose, you stop doing the minimum required. You really go deep within yourself. You become a creator. You become willing to go above and beyond the “call of duty.” You put your soul into your work. You genuinely seek to address the particular problem you’re trying to solve. You genuinely care about the people you’re serving.”

Dan Sullivan, Who Not How

It was not until after I learned from many experiments, failures and some successes over the next 4 years that I found congruence in serving the needs of investors, tenants and neighborhoods together with leveraging my experience, strengths and personal passions. Along the way, here are the problems (opportunities) we became committed to solve:

  1. Syndicate private equity to directly serve investors We syndicate the majority of our investments among a group of private investors, sometimes up to 40+in a single project, that we get to know and build relationships with over time. This creates a rewarding ecosystem where we provide access investors with access to opportunities that deliver financial returns. I found this significantly more fulfilling in comparison to institutionally managed investment funds that have several layers between the investment fund vehicle and the investors they are serving. Don’t get me wrong – institutional investment funds, ie Blackstone, Starwood, etc make great joint venture partners for many reasons (and we continue to selectively pursue them) including funding 90% of the equity for a given project. That being said, they are mainly composed of employee pension funds, where employees invest a portion of their hard-earned compensation toward retirement. This structure makes it impossible to actually meet and develop a relationship the individual investor you are servicing.
  2. Having Sponsor control to add more property value over long-term holds – Another benefit of having multiple investors in an investment syndication is that it gives us control as the Sponsor or general partner to run day-to-day operations and make major decisions on when to sell vs refinance and hold. Sponsor control comes with fiduciary responsibility and provides great opportunity to add value to the property and ultimately the neighborhood in multiple phases over a long-term holding period. In contrast, institutional funds rarely provide Sponsor control beyond day-to-day operations. The fund manager sets the property business plan according to the fund’s timing objectives to invest, add value and get out as soon as possible to achieve their target time weighted return or IRR. This has a higher likelihood of leaving property value on the table, which works against the Sponsor, the fund’s investors and ultimately the neighborhood community.
  3. Private investors need both superior risk-adjusted returns AND after-tax returns Commercial Real estate investments provide attractive tax shelters for private investors in the form of depreciation, 1031 like-kind exchange and most importantly the complete tax exemption for cash-out proceeds from refinancing. This behooves private investors to invest in long-term real estate strategies that provide annual return on investor capital through rental cash flow and return of capital through refinance. This also aligns with our approach in #2 to hold assets long-term and add value in multiple phases.
  4. Retail disruption creates mixeduse opportunities – We view retail spaces to provide an opportunity to reduce or re-size the amount of retail needed and repurpose the balance of the space to achieve higher and better uses. The internet’s disruption of physical retail officially began when Amazon bought Whole Foods in 2017. Almost overnight, we saw an overabundance of retail space in the urban cores and suburbs that needed to be repurposed into higher and better uses. In my prior life I also saw first hand how municipalities required retail ground floors and institutional investor-developers just tried to pencil in the lowest possible rent to get by without thinking about how impactful these spaces can be as the first impression of community creation (or lack thereof).
  5. Mixed-use innovation to serve and achieve more with less space – We take vacant and underperforming properties and give them a new life through community environments that create a diversity of uses in a project. In some cases this involves converting vacant spaces into much-needed housing. In other cases its as simple as taking a larger apartment, office or retail space, subdividing, renovating and leasing it in smaller spaces to service more tenant needs. In all cases, the COVID-19 pandemic has accelerated the need for mixed-use from being a steady want to a crucial need .
  6. Focus on fragmented and underserved small-to-middle market investments – In focusing on boutique assets in the $2-50M range, our institutional operational experience becomes our competitive advantage in finding pricing inefficiencies and dislocations in more opportunities within in a fragmented space with mom-and-pop and private owners of legacy assets that are underutilized and underperforming. Our institutional approach and processes are in turn provided as a value to our investors – high net worth individuals and family offices alike – when we execute and communicate our progress on each property business plan.

To pull it all together into congruence: We take dying properties and give them new life. Spaces that harmonize living, working and community. This creates multiple income streams for our investors over a long-term investment period to generate attractive after tax returns. When communities prosper, all stakeholders prosper.