Large private equity real estate firms often invest in trophy buildings, from the Willis Tower to the Cosmopolitan Hotel in Las Vegas. The commercial real estate investments that are often more lucrative than owning trophy buildings are less obvious and less visually attractive.
Certain smaller private equity real estate firms have the ability to identify investment opportunities that aren’t necessarily “brochure quality”, but offer “attention demanding” performance. Once these opportunities are identified, private equity firms unlock trapped value in the property through capital improvement plans that enhance the overall tenant experience, which, in turn, generate higher rents and ultimately increase investment returns.
This is known as a value-add strategy, and it involves strategic upgrades to a property’s physical condition, operations, and capital structure. By using these three strategies, the private equity funds run by the firm I work for have earned an average of 24 percent annual return for our investors since 2011.
Conduct Physical Upgrades
Well-designed renovations can help re-position a property to attract new tenants and boost rents. Often, office buildings need updates and renovations only to common areas and corridors, keeping tenants and their cash flow in place during renovations.
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For example, the private equity real estate firm that I am associated with conducted these types of physical upgrades on a class B office property in the hottest submarket of Dallas. Our investment fund, which is made up of a combination of individual investor equity and our principals’ co-invested equity, acquired this office property which was often overlooked by prospective tenants due to its need for a good facelift. In order to boost occupancy and command a rental rate increase, we refinished the building’s exteriors and renovated the common areas, lobby, and restrooms.
In apartment complexes, a new manager and an infusion of capital for renovations can make a huge positive impact on value. Upgrades to kitchens, bathrooms and common areas, as well as increasing resident services have all proven to be successful strategies in our past investments. For example, in a Chicago Class A mid-rise apartment property, we relocated and expanded the fitness center, improved the rooftop patio and reconfigured floor plans to add five new units to the property, adding more than $1 million in value to the building.
Get a Better Manager
Improving the management and marketing of commercial real estate offers another path to value and performance enhancement. When a property has rents that are lagging those of comparable properties, the property may by a viable candidate for improvements to maintenance and marketing efforts. Opportunities for operational value-adds are often caused by shifts in the property’s surrounding business climate, an owner that does not have adequate commercial real estate investment sophistication, or an owner that simply does not have the capital necessary to keep up with maintenance and marketing.
An example of this was our investment in Village Park at Palatine, a 1977 vintage, 448-unit apartment community in a high-quality suburb of Chicago. The former owners of the property had not adequately maintained the property and as a result of this the property managers were unable to successfully market the asset. This presented us the opportunity to give the asset a rebirth by purchasing the property at an attractive price and replacing the property management to re-brand the asset after conducting physical upgrades. Bringing in a new management team that had a better ability to market the asset utilizing its new image and brand, “The Clayson”, helped us to boost occupancy, increase rental rates. Improving occupancy and increasing rental rates will lead to significantly enhanced returns compared to those earned by prior ownership.
Restructure the Capital
Private equity real estate funds can also add value by stepping in when there is more than one owner of a property. If the partnering owner’s strategies diverge and one owner wants to invest elsewhere, or disagrees with changes to a business plan, a real estate fund is uniquely positioned to buy out one of the partners ownership in the property. This move is referred to as a recapitalization, or capital restructuring.
A recent example of this is when our company took over an ownership interest in the property from an insurance company. The other owner of the property wanted an equity partner to help them pursue more ambitious goals for the property and the insurance company wanted out. Our expertise in creating improved amenities and adding additional development to sites was a key factor in striking a deal for the recapitalization.
Private equity real estate funds also step in with timely capital investments when a commercial real estate investment is stabilizing its tenant base and new financing options are needed. An operator may need new capital, or investment, to renovate or re-purpose a building to make it more desirable and drive rents higher. New capital can also can help pay off debt to allow for new debt financing at more attractive terms. This is a strategy that my company has executed very successfully in a number of our investments.
