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Does Value-Add Really Offer Downside Protection?

August 9, 2021

A common refrain in support of value-add investment strategies is that they offer downside protection since the business plan is increasing the income and value of the property, thereby decreasing the negative impacts of weaker performance and valuation environments. Conceptually, this makes sense, but does it play out in the real world? To answer this question, we must define more specifically “downside protection”. When people make this point, they are usually pointing to a higher stabilized DSCR or lower LTV when defining downside protection in this context. This can demonstrate downside protection since NOI can decrease by a certain extent and still breakeven. Similarly, the asset’s value can decrease while still maintaining an equity value in excess of the cost basis.

While DSCR and LTV are great risk metrics, it is harder to judge a value-add investment by these numbers since they do not account for the execution risk associated with the business plan. For example, if a deal stabilizes to a strong LTV and DSCR, it says nothing about the riskiness of the business plan to achieve those metrics. However, if you look at the going-in LTV and DSCR, the investment might look unreasonably risky since a heavy value-add may have a very high LTV and negative cash flow (below 1.00x DSCR) upon takeover.

So, while it is true for a stabilized asset which has already been value-add to have more downside protection given the favorable cash flow and value relative to cost basis, the risk of the business plan must be considered. Today, many value-add opportunities trade for 3 to 4% cap rates, which means the margins are extremely thin or negative from the outset depending on the financing. In a scenario like this, downside protection is somewhat limited. The only place you can go (need to go) is up! Meanwhile, if you’re able to buy a stabilized property with no meat on the bone at slightly above a 5% cap rate, you have great downside protection day one, since you don’t have to increase revenue, decrease expenses, or make capital expenditures to enjoy strong cash flow and the LTV/DSCR are reasonably strong without taking any execution risk.

To me, downside protection is mostly determined by capital structure. A solid investment can be overwhelmed with too much leverage, requiring the investment to perform perfectly to refinance or sell positively. The term of the debt, whether it be short or long, also contributes to downside protection. A shorter maturity necessitates value creation to occur in a shorter period and doesn’t offer the investment opportunity to amortize the leverage down. Personally, I’m not a fan of amortization because I’m looking to maximize cash flow for myself and my investors. However, it is good to know that the amortization function exists after the initial interest-only (IO) period expires on our 10-year debt. If all goes as planned, we very well may refinance or sell prior to the expiration of the IO period, which will optimize cash flow. But if the property or the market underperforms, the consequence is not substantial and hopefully temporary as the long-term capital structure protects against selling in an adverse time.

I’m not saying all bridge loans are bad – we have been extremely successful utilizing bridge loans in situations that call for it. However, we are seeing rampant use of bridge loans for deals today which we feel do not justify the added risk and essentially create a mismatch between the investment and the capital structure. I’ll talk about this in further detail in my next article – see you there!