Arbitrage and Optionality
Every value-add real-estate project must offer an arbitrage and/or optionality opportunity to create value.
Arbitrage can mean that you can increase the value of the property by:
- Increasing rents to market.
- Improving quality to attract higher credit and/or higher paying tenants.
- Adding ancillary services to increase revenue.
- Restructuring leases and/or operations to increase profitability.
- Expanding a property on additional land.
Optionality means capitalizing on non-obvious upside:
- Ability to profitably adapt property use, ie industrial -> retail, office -> storage.
- Land is naturally worth more than the building, ie a "covered land play".
- A portion of the building and/or land can be sold to recoup a significant portion of the basis.
- Property and/or land is zoned, or can be re-zoned, to a higher and more profitable use.
- Natural rent growth driven by desirability of the area / population growth / new infrastructure nearby.
Optionality can also mean that financial markets can make your property more valuable.
- The asset class is “institutionalized” and cheap capital flows in.
- Cost of debt decreases, increasing all asset values.
How We’ve Pursued Arbitrage
So far we have focused solely on projects that offer arbitrage opportunities. Increasing rents to market, filling vacancies, light capex to improve rental rates, and adding additional services (and fees) to increase revenue. Some of these projects have come with optionality: a extra few acres, prime location for redevelopment - but those were only the cherries on top. Every deal has been “value add” in an obvious sort of way.
Unfortunately, in any attractive market or asset class today, the perceived risk of marking-to-market is essentially 0, and therefore properties are being purchased as if rents were already elevated. Proforma cap rate = market cap rate, essentially.
Vacancy risk in these same asset classes is similarly priced very low, except in self-storage. We have found opportunity here; our last two purchases were a 30k sqft facility (closed Jan 12th) which we have leased from 59% to 73% occupancy in just 4 months, and a 24k sqft facility (closed April 27th) which we have rented 20 units in the last 20 days. Self-storage properties typically lease up slowly, and there truly is significant risk in most markets, but we have been successful in predicting a market and facility’s lease up potential and are confident we can continue to do so in the future. Going forward, we will continue taking on these types of projects when they meet our requirements.
We have chosen these sorts of projects because of their return potential. These projects have all been essentially very low-risk (in my personal opinion), very conservative, and targeted a high return % (17-27% IRR). We’ve chosen this sort of deal for two reasons:
- As a newer sponsor, it has been very easy for me to raise capital for deals like this.
- I sleep very well at night feeling confident in our ability to knock these out of the park.
Eventually, though, all good things must come to an end. The secret of self-storage got out in 2021/2022 and almost all arbitrage opportunities disappeared. I wouldn’t be surprised if eventually lease-up in good markets was priced in soon.
The issue with arbitrage opportunity is that they’re often very obvious. In self-storage, multifamily, and hospitality rents are completely transparent and leasing data can be found with cheap software.
Industrial, retail – any B2B real estate asset class, rents are opaque but they can be found by an expert. Costar has moderately accurate data, but advantages can be had by befriending the top local brokers and owning in a market. Time in a market compounds your advantages in these asset classes. Therefore, we will be spending significantly more time here than in self-storage for the foreseeable future.
Opportunity in Optionality
Optionality, though, regardless of asset class, is hard to see. To make a great bet with optionality, one needs to understand multiple asset classes including land, where cities are growing, where new infrastructure projects and developments are coming in; where the money is flowing.
One example of a project with optionality would be purchasing a warehouse with a 5-year lease that just so happens to be near the hottest biking trail in town. That warehouse may rent for $6 NNN now, but what if you could convince the city to allow you to turn it into a brewery? At the end of the lease term, you may be able to rent that same space for $15 NNN. Assuming you fail, you may achieve an 8-12% IRR. If you’re successful, you may achieve 30-40%. Downside is fairly limited, upside is very attractive. Essentially, it's a "free" call option on your ability to convert the use in the future.
Another example could be purchasing a low-er cap rate RV or drive up self-storage facility in a gentrifying part of town. Small cash flows today, but if the city continues to grow in your direction, you could own a prime site for a new condominium complex. Worst case scenario, you hit 4% cash-on-cash returns for 5 years and sell for a 6-10% return. Best case the dirt is worth 2x your basis and you knock it out of the park.
Finally, you could just be “right” about interest rates and capital flows the same way that every investor from 2010 -> 2022 was. To date, we’ve seen cap rates expand across asset classes from the 4-5% range to the 6.5->7.5% range almost entirely due to lender pullback and rate increases. Capital poured into real-estate the last few years and has begun to find a safer and more attractive home in debt. If you’re willing to make a bet that, at some point in the next 5 years, interest rates will shrink back down to 2021 levels, you could buy many high quality properties today, do absolutely nothing, and profit handsomely.
Optionality is how singles turn into doubles.
Moving Forward
The reputation we have built in self-storage means that we see nearly every deal that fits our buy box, and I expect to buy 1-2 deals per year that fit our mark-to-market or attractive lease-up criteria. Not many, but enough to stay in the game. But self-storage is a highly commoditized asset class and therefore local knowledge and relationships are not rewarded. Going forward we are focusing on industrial in which I believe over time our relationships will compound and we will be able to scale. Our core focus will be in a few specific regions of Atlanta, Greenville, and Charlotte, all locations in which I have deep relationships and market knowledge.
I expect significantly more deal flow in industrial, but not immediately, since it requires far more expertise to understand market rents and demand – it’s a hyper-local and information-opaque asset class. I do not expect industrial to get the “self-storage” treatment; it’s hard to just jump in, it takes a long time to learn, and local presence is required.
In addition to taking on projects solely monetized via arbitrage, we will be offering opportunities that we can strike in many ways. The goal is to acquire high quality properties on sale because of rate levels, or see something in the properties that others don’t (optionality). As our knowledge and relationships in each of these markets deepen, the frequency at which we will recognize these opportunities will only increase.
Thank you all for reading. I hope you had a great Memorial Day Weekend and I hope to bring you all some very exciting projects that we can work on together soon!
As always, I’d love your feedback – please just reply to this email!
All the very best
Ryan Auger
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If you'd like to learn about our deals as they come out, let's set up a time to meet over a 15-30 minute video call whenever you're available: https://calendarbridge.com/book/q5LjGOm. Once we've had the chance to connect, you'll be added to the official deal distribution list ("deal list") where you will receive a link to our deal room (full 5y financial projections, offering memorandum, site images, video deal walkthrough, etc..) and all deal rooms going forward. Accredited investors only (am I an accredited investor?).
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