By Yuriy Gelfman, principal at Olive Tree Holdings
Real estate investing is best viewed through the relatable lens of child rearing. An investment enters life with two parents — a limited partner (LP) and a general partner (GP).
The parents really want their little investment to do well in life. The investment’s journey through life is full of obstacles and potential dangers, but through this metaphor, we can breathe life into a topic that can be dry on paper.
Pre-Birth Planning
An investment is born out of the good intentions of the GP. But how does the GP select the right opportunity to invest in? In the multifamily segment, there are 13 million apartments contained in large communities split among tens of thousands of properties in several hundred markets. This really is a lot of real estate.
Yuriy Gelfman, Olive Tree Holdings
It’s important to not fall in love with any opportunity based on arbitrary or subjective reasons. We seek opportunities that are: 1) scaled 2) located in growth markets 3) acquireable at a large discount to replacement cost and 4) are underperforming immediate peers.
Each acquisition takes a significant amount of time to identify, negotiate, arrange financing for, staff, asset manage, construct and ultimately refinance and/or sell. Each of these stages is time-consuming; for most, the amount of time necessary to invest per asset does not change much whether the deal is 30 units or 300. Therefore, focusing on larger deals can be a means of better scaling time.
Extensive studies of both real estate and equity market investing have shown that growth lifts all boats. Growth cities tend to do better in good times (economic expansions) and bad times (recessions).
Simply buying an asset in a market that is cheap today at a low basis and thinking it’s a brilliant investment is inadvisable. Investors should aim to buy at a good price today and know that in two to six years, this investment will become considerably more valuable.
Growth markets come in two flavors: markets that have a history of above-average growth where historical momentum should carry into the future; and those where a change of trend is taking roots either through business relocations or the birth of new industries that have strong growth drivers.
Capital sources should also consider investing in assets that can be acquired at a significant discount to replacement cost — essentially viewing real estate investing through the prism of commodity market investing. Some apartment complexes have nicer finishes — inside and out — than their peers, but all, if adequately maintained and managed, are apartments.
By and large, a 1970s complex should be less valuable than a 2020 complex in a similar location. Like living organisms, these assets age with the passage of time, and if they are not overhauled periodically, their tenant appeal and cost to operate degrade as the years go by. This leads to lower revenues and higher expenses per unit, as well as lower remaining useful life.
This means that buying a 30- to 50-year-old asset for a similar price that a new one would command is generally not a sound investing strategy. In the short run it can work, in much the same way that bad stocks can go up temporarily. But in the long run, if you are in the value-add game and seek to earn superior returns, you need to buy older assets at appropriate discounts to replacement cost.
At Olive Tree, this discount ranges from 30 to 50 percent depending on vintage, location and physical condition. Adhering to this strategy affords our investments a solid footing out of the gate.
Lastly, there is value to be had by focusing on underperforming multifamily communities, as these assets can be acquired at a multiple of in-place rents and income. To the extent that the asset has highly depressed rental rates or occupancy and is not earning a reasonable NOI, we further discount the basis.
The presence of an underperformance gap relative to similar communities allows owner-operators to improve rents and income quickly without basing their investment thesis on achieving top-of-market, “value-add” rents.
We certainly work hard to meaningfully exceed the average of our sub-market peers through intelligent value-add renovations, amenity improvements, savvy marketing strategies and a host of other initiatives. But in order to succeed, our investments almost never need to achieve top-quartile rents. They simply need to perform at peer-average levels. This focus on underperformance further de-risks our investment strategies.
As such, with the right pre-birth planning, our little investments can enter life on sound footing.
Nurturing Growth
The right preparation pre-birth is critical, but it matters little if not accompanied with the right parental capabilities and strategies after birth.
After a prospective acquisition becomes an owned property, it is critical to pivot to executing the various strategies that will allow it to mature predictably. These key focal points include 1) fortifying onsite teams, 2) addressing deferred maintenance remediation, 3) implementing value-add renovations, and ultimately 4) achieving significant rent and income growth.
When taking over an underperforming apartment complex, there is often a visible degree of physical neglect from the prior owner. But the same owners that fail to invest in their physical assets adequately often fail to invest in the community’s employees properly as well.
We try to ensure that our residents receive strong customer service, and that our asset is professionally managed on a day-to-day basis. This is the responsibility of the onsite property management team.
Oftentimes, a number of the onsite professionals need to either be retrained or replaced immediately after acquisition. For these reasons, it’s important to assess the onsite teams thoroughly pre-takeover, as well as to have recruiting capabilities in-house and maintain modular training resources internally. Investing in onsite teams is a key ingredient for facilitating a successful repositioning.
Underperforming assets tend to have varying degrees of deferred maintenance. During pre-acquisition due diligence, it can be helpful to thoroughly inspect prospective targets to develop building-by-building and to devise unit-by-unit catalogs of deferred maintenance. This allows owners to quickly transition to fixing problems as soon as the asset has been taken over.
At Olive Tree, both the pre-acquisition due diligence and executing the post-takeover improvements are handled by our internal construction management department. This group makes sure that we know what the problems are and how much they will cost to fix and ultimately manages the process of fixing them. Executing property turnarounds without having such a team in-house is a challenging prospect.
As previously noted, basing investment cases on achieving top-of-market renovated rents can be a precarious strategy. Our construction and asset management team invests significant energies into creating asset-specific, unit-interior and communal-amenity improvement plans.
We focus on items that sit at the intersection of several forces: 1) what tenants want 2) what the community is missing 3) what the current and prospective tenants are willing to pay for and 4) what the highest return on invested capital improvement options is. The intersecting answers to these questions tend to lead toward intelligent interior and amenity improvements that are uniquely suited to drive accretive NOI growth for that community.
Ultimately, for an investment to make its partners happy, it needs to drive significant revenue and NOI growth. Through the various pre-acquisition and post-acquisition processes described above, investors can go a long way toward ensuring that their deals are strong, sound and equipped with exceptional odds at making both the LP and GP parents happy and proud.