Everybody loves a good sale.
But just because something is 'on sale,' it doesn't mean it's a good deal.
The distress in the office market has been widely expected, and the real estate media has intently reported on the biggest and most recent defaults, short sales, etc.
Many have remarked on how many of these buildings are selling ‘for cheap’ when, in reality, only very few are worth something.
As it turns out, buildings are expensive to hold and maintain, and those expenses can quickly go through a reserve when a building is barely occupied.
A building purchased for $4mm with $6mm in annual expenses and $500k in revenue is not a good deal. It’s a particularly bad deal if there is no plan to cover or mitigate those expenses anytime soon. And if there is a plan and that plan relies on the willingness of other parties (like tenants with a 10-year lease), then the underwriting better contemplate that risk somehow.
Never mind that the last guy who just lost it to the bank paid $22mmn and had $18mm left on the loan.
That doesn’t matter.
What a building is worth (even if it’s ‘on sale’) has nothing to do with what someone else paid for it, levered it for, or thinks it’s worth.
Sure, a redevelopment plan allows someone to pay more than the next guy who is planning to “simply stabilize” a failing office building in a market that doesn’t want it (this time will be different), but that redevelopment plan better be solid.
It should not rely on the magical thinking that since it’s “on sale” it must be a good deal.
At the end of the day, a distressed deal is still a deal, and the fundamentals still apply.
All costs need to be considered.
Cost to purchase
Cost to carry (don’t forget utilities & taxes!)
Cost to vacate
Existing leases can be the biggest risk when purchasing a distressed office building as part of a redevelopment strategy. If the time to vacate and demolish is longer than the time it takes to re-entitle for another use is, it can be a problem, and a big one. Especially if one or a few of the tenants refuse to negotiate an early termination.
It can also be a problem if the building is going to be empty for an extended period of time while design and permits are in process.
Either scenario must be contemplated in the underwriting.
Cost to redevelop
Design, marketing, cost of capital, hard costs, permits, legal, etc.
The value of what you put in should be considerably less than the value you can sell it for. In the retail world, a helpful rule of thumb is that you need to sell something for three times what it costs to make.
While this multiple varies in real estate depending on the market, the concept still applies. If a quick calculation that contemplates all expenses doesn’t yield a reasonable return, it’s not a good deal.
The perception that something is ‘on sale’ makes people buy stupid things they don’t need. This applies to impulse buys at the convenience store and to real estate.
Outrunning our human nature is unlikely, but being aware of it helps make it not impossible.
*I don’t like this generalization. Every distressed asset has specific circumstances that led to its current situation, and there are too many variables to generalize.
In addition to our development work in NY, MADDPROJECT provides fee development and professional project management services across the US.
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