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Era of Execution

December 2013

P.J. Yeatman

Head of Private Real Estate, CenterSquare Investment Management


Jeffrey B. Reder

Senior Vice President, Private Real Estate, CenterSquare Investment Management

Executive Summary

After the financial crisis, investors could buy high-quality, income producing real estate at attractive cost bases and generate opportunistic yields. Market participants simply needed to have the financial resources available to capitalize on the opportunities available during what was an "era of acquisition." Now, we have entered an "era of execution" in which investors must create value and execute strategically to achieve attractive risk adjusted returns.

Since the financial crisis, investors have flocked to core assets and paid a premium for the perceived safety of their income streams. But they may face risks that are greater than those they perceive. Investors have recently had less appetite for value-added investment strategies than for core assets. Underperforming, capital-starved assets have been kept alive by low interest rates, and the opportunity to acquire and recapitalize them has now arrived. In the current market we see properties suffering from underinvestment by financially distressed owners. We see assets that are not functioning optimally in their current state but which have the elements they need to be converted into properties of great worth. These raw materials for value-added real estate strategies exist and can still be acquired at an attractive cost basis in a world where current yield has been significantly overbought. We believe that a middle market, value-added strategy represents a sweet spot in the market for creating value and reducing risk. A value-added strategy also provides an opportunity for liabilityladen providers of retirement benefits to meet their actual return hurdles on a current basis while accruing additional total return that they can realize in the future.


Seismic change is often destructive but can also create awe-inspiring beauty. In Alaska, extreme natural forces — tectonic plates colliding into each other with tremendous power — over time yielded majestic mountain ranges and an array of mesmerizing landscapes from glaciers and valleys to lakes and rivers. Situated along the Ring of Fire, one of the most geologically volatile regions in the world, Alaska can be a tumultuous and challenging place. Earthquakes, tsunamis and volcanoes all loom ominously as future risks to the environment. Yet it is also rich in potential resources and home to unparalleled natural beauty. Similarly, the ground-shaking disruption of the capital markets' foundations in 2008 dramatically altered our economic landscape. The magnitude of the initial shock decimated the investment universe as we knew it, and we continue to feel aftershocks today. The current economic environment remains fraught with uncertainty and potential threats to stability persist, yet opportunities to prosper exist for those with the vision and resources to navigate the rugged terrain. Even in the most turbulent of environments, opportunity exists for those who thrive during times of change.

Much like the settlers who went to Alaska during the late 19th century in search of gold, those with the courage and capital to venture into the bleak real estate investment landscape following the recession were able to harvest great value simply by acting when others could or would not. It was the "era of acquisition," in which almost any real estate investment could produce significant gains. Today, the easy-to-find opportunities have mostly been mined. Investors must now seek to create value from the raw materials available in order for the opportunity to generate compelling returns. We have moved into an "era of execution."

All that Glitters

Gold is precious due to its scarcity and investors have historically paid a premium for it in times of economic uncertainty. They view it as a store of value, a tangible asset to be accumulated during periods of distress, when its price often climbs substantially. Core property is the gold of the real estate investment universe. Since the financial crisis, investors have clamored for the perceived safety of its income streams and the comfort of owning the highest quality assets. However, we believe these features are overbought today and the premium values no longer offer compelling risk adjusted returns. In fact, the significant fall in the price of gold since its peak in August 20111 could serve as a potential leading indicator for core real estate going forward.

Rather than gold, carbon is our element of choice. Carbon is present in all known life forms and is the ultimate foundation upon which to create. It forms more compounds than any other element and can be converted into a variety of useful and valuable products. Value-added property is the carbon of the real estate investment universe. In the presence of changing conditions, it can be restructured and its form altered. Carbon can be combined strategically with other elements and forged into something far more valuable such as diamond, one of the most durable and beautiful materials in the world. We believe the most compelling real estate investment opportunity that exists today involves finding the best carbon-like properties, then applying the necessary strategic improvements to forge core-quality assets. These improved properties can then be sold at a significant profit to investors willing to pay a premium for the finished product.

Value-Added Real Estate Investment

Value-added property is a category of private equity real estate investment that involves properties that exhibit financial or operational challenges, require physical improvement, and/or suffer from capital constraints. The strategy involves acquiring these assets at an attractive cost basis and executing a plan to resolve their deficiencies, stabilize their income streams and increase the overall value of the properties for disposition. Value-added real estate has historically fallen between core and opportunistic real estate strategies on the risk-return spectrum, representing a middle ground for investors with the acumen and capital to take an active role in improving and monetizing their investments.

A value-added investment strategy involves the two primary goals of income growth and risk reduction. The successful execution of a business plan generates an increase in net operating income (NOI) through improved tenancy, higher rents as a result of targeted property enhancements and lower expenses or other improvements to the financial performance of the asset. In addition, asset-level risk is decreased by establishing durability in the income stream, resulting in lower risk to the owner and a lower potential cap rate upon disposition. "Cap rate" is a real estate industry term that defines the relationship between NOI and the value of an asset (Figure 1). Superior assets trade at lower cap rates (5 to 6 percent) and inferior assets trade at higher cap rates (8 to 10 percent). An investment process that focuses on both increasing NOI and reducing asset level risk (therefore decreasing the cap rate upon sale) results in a further increase in value of the asset at disposition and an improved total return on the investment.

Figure 1 // The benefits of adding value

Figure 1 // The benefits of adding value

Value-Added vs. Core

Core real estate, generally defined as high-quality assets in prime locations with stable cash flows in place, has long been regarded as a safe, yield-producing investment option. The first real estate assets to see meaningful improvement following the financial crisis were core assets in major central business districts, which began attracting foreign investment in 2009. This makes sense, as risk aversion led investors interested in real estate to those assets with the lowest perceived risk on the spectrum. Since 2009, investors have continued to flock to core real estate investments and values have shown continuous strength in response to the demand.

While core real estate continues to produce stable yields for owners, the cost to acquire that yield has grown significantly relative to other asset classes. In addition, as interest rates and/or inflation rise from current levels, these stable, contractually-fixed yields will become significantly less attractive and core owners will have limited options to increase their yields. We believe that this combination of high cost basis and lack of opportunity for increased yield creates a very real risk of substantial capital loss in core real estate investments that exceeds the perceived risk for the asset class.

Investors traditionally perceive value-added real estate investments as having higher risk than core investments. However, experienced real estate investors can rectify the income instability, operational difficulties, or physical deterioration in value-added investments. Because the underperforming transitional assets that serve as the raw materials in value-added strategies remain attractively priced, assets burdened by such traits can be acquired at low cost bases and redeveloped into institutional-quality assets at significant discounts to their competitive set. The cost basis advantage provides downside protection in the event of an economic slow down, while the opportunity to increase yield through improved NOI enhances value as markets improve. The low basis and yield growth potential in value-added assets make their actual risks much lower than their perceived risks. This ability to invest with margin may create significant risk-adjusted returns (Figure 2).

Figure 2 // Core versus value added real estate

Real Risk > Perceived Risk
Perceived Risk > Real Risk
Core real estate has lower perceived risk due to the supposed protection resulting from stability of cash flow and location

However, as interest rates and/or inflation rise from current low levels, core investments may be subject to risk of substantial capital loss due to high cost
Transitional assets are perceived to be more risky due to their lack of income stability

However, the raw materials of a value-add strategy can be acquired and redeveloped into institutional assets at a significant discount to their competitive set

This ability to invest with margin may create significant risk-adjusted returns
High Basis + Low Yield = High Risk/Sell Low Basis + High Yield = Low Risk/Buy

We see an opportunity to arbitrage the mispriced perception of risk that currently exists between stabilized core assets and fundamental value-added raw materials. This pricing discrepancy exists largely because the majority of investors are risk-averse and willing to compete for the perceived safety of long-term leases at the cost of accepting minimal yields on core assets. In fact, these core assets present potential exposure to an ultimate loss of capital, due to their lack of inflation protection, and an elevated cost basis, which burdens the assets in perpetuity. Opportunities abound to acquire fundamentally sound assets at highly attractive bases which many investors currently perceive as having challenges or risks which they don't have the appetite for. For those with the necessary capital and experience, these raw materials can ultimately be transformed into core-quality properties with reduced risk profiles that many investors will line up to buy.

Why Value-Added Now?

Real estate values were significantly impacted by the global financial crisis of 2008-09. With the exception of cash-flowing institutional assets in gateway cities, values have yet to fully recover. Many observers have compared the post-crisis real estate landscape to the market in the early 1990s following Black Monday. Indeed, one notable parallel is the similar delay in the recovery of private assets following the recovery of public market asset values. In the current cycle, the leading public market values have recovered while many private valuations have not. We can infer that we are in the midst of an optimal private market investment window, as Figure 3 shows.

Figure 3 // Extended Window of Opportunity

Figure 3 // Extended Window of Opportunity

Regulators' responses to the two market crises were markedly different. In the early 1990s, the formation of the Resolution Trust Corporation in response to the market crash forced distressed owners to liquidate real estate investments, flushing assets into the market and allowing investors to purchase them almost immediately at extremely low cost. The regulators' approach since the financial crisis created a very different scenario. Financial institutions were not forced to dispose of underperforming real estate assets during the downturn, and instead, were encouraged to "extend and pretend", limiting mark-to-market valuations and holding significant inventories of troubled assets. These assets have continued to deteriorate because distressed owners are unwilling to sell, but are unable to invest in them. We believe that over the next several years, the physical and capital needs of these properties will require significant new infusions of capital, prompting owners to finally dispose of them. Furthermore, rising interest rates will put additional pressure on owners to sell such assets. For an experienced value-added manager, this slow infusion of low cost value-added raw materials into the market presents a significant opportunity.

The relative pricing of core compared with value-added investments in the current market presents a further reason for purchasing transitional assets in the near term. The yield embedded in stabilized, yield-generating core assets has been overbought and many investors continue to overpay for it. The total return potential in value-added investing, however, has been significantly underbought since the crisis and during the recovery. A value-added investor can benefit from this potential by purchasing underpriced transitional assets, converting them into stable properties and selling into a yield-hungry core market. It is our thesis that creating or optimizing income streams purchased at a relatively low basis provides for greater margin and downside protection than purchasing existing current yield in today's unbalanced market. Particularly because the economic environment is dynamic, yield can be considered a fleeting aspect of an investment, while an attractive cost basis is a permanent component that will drive relative investment performance.

Finding Value-Added Opportunities

We believe these opportunities exist where capital is less plentiful. As investors focus heavily on primary markets and current income, the abundance of capital targeting the same pool of investments aggressively drives prices upward in the face of intense competition. The ability to source investments that provide a more compelling value proposition exists by targeting opportunities currently facing a scarcity of capital. These include transitional assets and properties in secondary markets (see Figure 4).

When evaluating value-added investments, it is prudent to consider the seller of a specific asset and seek to buy from unnatural or disinterested owners of real estate. These owners can include banks, special servicers and insurance companies, as well as municipal entities, religious organizations, hospital systems, or corporations that own their own assets. However, even assets owned by experienced real estate investors can present attractive acquisition opportunities when they are burdened with a high cost basis or an owner's inability to see a path to value creation due to their negative history with the asset.

Figure 4 // Real estate capital flows

  Abundant Scarce
Market Major Secondary
Income Income Producing Transitional
Size Large Middle Market
Sponsorship Institutional Entrepreneurial

Another criterion for evaluating opportunities is the ever-popular "location." Target markets should balance high barriers to entry with potential growth. High-barrier urban markets generally benefit from cap rate compression during economic growth, while exhibiting a measure of insulation from decreases in value during poor economic periods. Some lower-barrier markets present more risks in terms of supply and liquidity, but potential growth can compensate for these risks if an investor buys the right asset at the appropriate point in the cycle. We believe the most compelling current opportunities exist for primary assets in secondary growth markets and secondary assets in primary growth markets.

Lastly, investors should look for significant potential for value creation by targeting transitional assets which have suboptimal income streams in place. Transitional assets require capital and active management in order to protect or increase their value and it is these assets' instability that provides the potential upside from the value-added investment process. In addition, these are the assets most likely to be acquired at significant discounts from unnatural or disenfranchised owners.

Strategic Execution

The successful execution of a value-added investment business plan is the most crucial determinant of the investment's performance. To ensure superior execution of the business plan and maximization of end value, we believe investors should utilize local operating partners to achieve a competitive advantage. Over the past two decades, the real estate asset class has taken its place in the global capital markets. However, property operation and management remains very much a local business, requiring deep knowledge of economic drivers, preferred locations and rental rates. Well-aligned joint ventures with proven local operating companies can be highly efficient and effective ways for institutional investors to gain access to quality investment opportunities, along with the operational capabilities needed to implement the turnaround of formerly-underperforming properties. The operating partner's interests are aligned through negotiated agreements which include meaningful co-investment and back-end economic incentives tied to investment performance.

The local operating partner model allows a national investor to have the superior, local intelligence about the market, tenants and history of an asset that can only be obtained with a constant presence in the local market. Such knowledge increases the accuracy of underwriting for each investment. In addition, quality operating partner relationships are important tools for finding new investments before they gain broad attention and for enhancing competitive positioning due to specific relationships with local brokers and/or sellers.

The CenterSquare team combines the local expertise and relationships of our partners with the institutional protocols and experience crafted across a variety of property types through multiple investment cycles over the course of a 25 year history of institutional investment management. We believe active management is the key to realizing a successful investment in this asset class. Significant upfront research enables an investor to make compelling risk-adjusted investments at attractive bases, but the environment is a dynamic one. An ongoing assessment of the variables that impact real estate value is required.

At CenterSquare, every decision from initial evaluation through strategic execution to disposition is supported by disciplined processes developed over a lengthy history of real estate investment management. Active monitoring of the capital markets helps inform when to optimally harvest the value created. Often a sell decision is driven by completion of the business plan, but occasionally the market will compensate owners for future potential income not yet created. Continuous analysis provides us with the tools necessary to perform a hold-versus-sell analysis and evaluate whether future potential returns from taking the additional execution risk is worthwhile, compared to a return that could be realized today.


As the global financial crisis recedes further into history, the aftershocks and resulting impacts will continue to be felt. We believe that until the U.S. deals with its national and municipal debt, underfunded pensions and other structural issues, investors will continue to live with the threat that the tectonic plates moving beneath our feet will once again meet in a destructive collision. Accordingly, we feel that it is prudent to invest in assets that can be acquired at a competitive cost advantage with the potential for both increased yields through strategic execution and for enhanced total return through risk reduction. We believe that a middle-market, transitional asset, value-add strategy does just that now that real estate investment has moved from the era of acquisition into the era of execution.


1 Source: Bloomberg, as of November 2013

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