Part of the analysis of any commercial real estate transaction involves the categorization of the deal. From an investment standpoint, real estate deals can sometimes be defined as either stabilized or value add.
But the criteria for these categories can be subjective, and conditions can change in ways that move a deal from one category to the next.
So let’s get clear on the factors that play into each definition.
Stabilized or value add?
The occupancy rates of a commercial real estate asset play a big role in determining whether a deal is stabilized or value add.
Stabilized assets typically have at least 80% occupancy, usually at market rental rates. These deals are usually steadier and lower-risk transactions.
Generally, value add assets will have occupancy that is either below 75% occupancy at market rates or above 75% occupancy at significantly below market rates. These deals are higher risk, but they hold the potential for higher returns.
Value add assets call for improvement to increase occupancy rates, whether that means upgrading the condition of the building, refreshing the interior space, or fixing other aspects of the property.
So how do you determine the category of a deal?
Don’t rely on the slapped-on labels within the slick marketing packages from sponsors or brokers. These categories are gray areas with loose definitions and evolving conditions.
For example, market rates can significantly change over a period of a year. Sometimes an asset will be marketed as a true value add deal; this means that you need to get occupancy up by a precipitous amount.
Other times, a stabilized deal still has a value add component. Even though the deal isn’t defined as a value add, there is some “meat on the bone” that offers additional upside. Perhaps you could take the deal from a stabilized asset at 85% occupancy to 95% or 100% occupancy. Or you could improve the market rates for that property by doing value add work.
Which is better?
In commercial real estate, there is no single “best” choice between value add or stabilized deals.
At Excelsior, we pursue both kinds of deals. It all depends upon the attractiveness of the asset and whether we think the story behind it makes sense.
As you assess each transaction, your job is to ask the right questions.
If a deal is marketed as value add, get clear on the condition of the building.
- Are there many required repairs to perform at closing?
- Does the building need significant capital expenditures to make it attractive to potential tenants?
- Is the future value a function of leasing, where you just need to get occupancy up? Or is there a substantial gap in the in-place vs. market rents?
- If a tenant leaves, does their space need significant tenant improvement dollars, or is it in good shape?
When a deal is marketed as stabilized, you need to understand the level of the occupancy and current weighted value of the rental rates and lease terms.
- What are the current variables?
- For example, if the asset is at 85% occupancy, what is the market rental rate as compared to what is standard? How long are the leases that are in place?
- A perfect clear-cut example of stabilization would be a 95% occupancy rate, with all leases expiring in 3+ years.
– In this example, there is minimal work to be done.
- Other stabilized deals might have leases that expire in the next 12-24 months. If so, there is a certain amount of risk in that deal.
– It could almost be construed as a value add because you will be doing a lot of work in the first year or two.
The bottom line is that you need to do your own homework to define any deal. Above all, you need to clarify the risk tolerance profile for your transaction.
Parse through how a deal is marketed, clarify the criteria that you need to assess, and thoroughly analyze the information that is provided. This level of due diligence will allow you to make smart decisions about an opportunity and whether it makes sense for you.
With over 35 years of experience, Chris’s philosophy boils down to being a humanist and an optimist. He doesn’t believe in the dichotomy of high potential vs. low potential human beings…
Ryan McCostlin is the CEO and Founder of Tailwater Dental, an adjunct professor at Vanderbilt University in Nashville, and he writes publicly online at ryanmccostlin.com.
AJ is a co-founder of Capstone Companies, the US’s largest privately owned multifamily brokerage. AJ currently sits on the board of Capstone and leads his development company, Catalyst Capital Partners, which has 14 multifamily projects in various stages.
Adrian Reid is a full-time trader based in Australia and the Founder and Trading Coach at Enlightened Stock Trading, which focuses on educating and supporting traders on their journey to profitable systematic trading.
A real estate private equity firm that owns and operates high quality multi-tenant office assets in emerging secondary markets.
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