There are many different strategies for investing in real estate and many buzz words thrown around such as generational, trophy, value add or core. As an investor, it’s important to understand what these terms actually mean and which style better suits your investing strategies.
A property might be described as “Value Add” when there is a high vacancy rate in the building(s), or the tenant’s lease is nearing the end of its term. While purchasing a building with few or no tenants paying rent seems like a bad way to invest, the low rent will bring the price of the property down while the empty space offers an opportunity for the investor to re-lease the space to a new tenant at a higher rate. There is often a capital expenditure involved in making the space ready for a new tenant and should be weighted against the likely rents to be achieved. The upside associated with bringing in new tenants to boost the rent roll is the strength of this investment style. This strategy offers investors a nice exit point, once fully leased, the property can be sold at a higher price. The relatively short timeline can be beneficial for active investors looking to redeploy capital into their next project.
The phrase “Below Market Rent” is not a strategy by itself, but is associated with “Value Add” investing. Acquiring a property that offers below average rent seems to be counterintuitive but has the same basic mechanics working as “Value Add.” Purchasing a property with a cap rate on par with similar tenants and below market rent will keep the sales price low, offering a nice entry point for investors. Re-leasing the property at market rent is where the investor will see the gains. The higher cash flow will lead an investor to achieving a higher price in the disposition of the property.
Purchasing “Value Add” properties with below market rents offers the possibility of higher returns, however they often require some work. This can be in the form of renovations to the property and the cost/difficulty of searching for a new tenant.
The “Generational” investing strategy is a significant shift away from the “Value Add” style of investment. “Generational” properties typically have strong, well-known tenants with great credit, in good locations on long term leases. All of these are attractive characteristics in a net lease property. Due to these aspects, they will typically sell at lower cap rates. A “Generational” property is typically purchased to be held for a long period, sometimes passed down from one generation to the next (hence the term “Generational”). Investors are willing to acquire these assets at high prices and low cap rates today, because of their long time horizon.
The “Generational” strategy comes with some drawbacks. The return on investment can be low, the purchase price high, and will tie up an investor’s capital for a significant time period although the asset will hold its value over the long term.
As for which strategy is better, it is contingent on the investor’s goals and preferences. “Value Add” properties can be lucrative for active investors who are looking for higher returns and are prepared with taking on additional risk. “Generational” properties are better suited for investors who want to see consistent returns for long periods of time and take on minimal risk. The trick is to find the right balance of risk and return that meets the individual needs of the investor.
The views expressed are the author’s own and not the views of ALM’s Real Estate Media Group.