“Vacant space is worth more than leased space”
I am starting to hear this phrase more and more from my sales broker friends. When you break that statement down, what it means is that an actual tenant paying rent is less valuable than the potential tenant who “will” pay more rent “when” the lease is signed. For most of 2006 and 2007, investment sales brokers cited that phrase to demonstrate why a high projected, not in place, rental rate for vacant space in an office building or a vacant rental unit in a multi-family property justified a high valuation. “Of course, when you and your team lease this vacant space, the building will be worth so much more!” was the oft-heard statement from a smiling broker.
The Fear of Not Buying Right
So is it “déjà vu all over again”?, to overuse an overused phrase. That is certainly the question we struggle with at Rising. The reoccurring question our investment committee has for our acquisitions team is “does it feel like we are buying this asset at a good basis?”. Often this isn’t an easily identifiable answer, especially in the world of opportunity investing. Since we are always looking to invest in projects or areas where the market has not quite moved, it’s often impossible to show historical comparative prices to justify an acquisition price.
In our real estate business, we look at deals primarily in California (from San Francisco to San Diego) but also in other “smart” cities like Seattle, Portland, Phoenix, Salt Lake City and Denver.
Our team believes that we are not at the peak of the investment cycle, but we are constantly aware that “trees don’t grow to the sky”. We pay close attention to our analysis, especially the going-in price. Most of our investments require significant capital to improve the asset so we have to be very careful that the acquisition price plus the capital costs do not drive the exit price so high that it isn’t realistic that we can sell at a price that meets our return requirements. Furthermore, the expected sale price cannot be justified by an argument that “it’s just different this time, it’s a whole new paradigm.” It must be grounded by historical comparative prices and replacement costs.
The Opportunities We See
We see real investment opportunities in two areas of the real estate investment spectrum at this time: opportunistic redevelopment and long term value investments.
Opportunistic: We like deals that require heavy lifting in terms of capital improvements and repositioning. Most often, these deals have some cash flow. We like to focus on why these projects were originally built and try to understand why they fell out of favor. We try to focus on what went wrong because we understand that, at it’s inception, such a project was envisioned, financed and leased…so it had a purpose and success at one point in the asset’s history.
We are interested in the assets that fell on hard times due to lack of sophisticated ownership or a location that had moved out of favor due to the shift to suburbia but lies in the path of revitalization today.
Opportunity, for us, also lies in ground up development in specific central business districts. On the development side, our focus is to entitle property for more valuable uses and sell rather than take construction and tenancy risk. While we have an expertise in actual ground up development, it is a more difficult proposition given the price of entitled land in most CBD’s today.
Value: We are also very focused on identifying residential, office and industrial deals that provide a current cash flow for a long term hold (10 years). We think there are a variety of opportunities in the space. In our investment thesis, we bifurcate this value space between deals over $20M and those under $20M.
Our pipeline for value deals is like a big fishing net. We find deals that fall into both categories, therefore, we are also separating our capital partners into two categories.
For over $20M deals, we are focused on our partnerships with private equity real estate firms who deal with Core Plus investments. For the under $20M deal, we aim to have strategic discussions with our individual investors.
The overriding concept of our value strategy is to identify assets that can “play through a cycle”. That means we want quality assets that have the ability for some repositioning but have a reliable cash flow stream through a cycle change.
We think our investors will value the current cash flow and the potential for upside. We also believe all of our value assets will have our “developer eye” for some sort of repositioning. Finally, we have great faith in our property management and asset management teams to create a tenant experience that is curated and unique.
“What Inning are we in today?”
This is the quintessential real estate panel question. Since it’s nice to believe that ‘history repeats itself and if we just look at history we can create a reliable investment strategy’, I understand why most moderator’s end a panel with such questions.
I am of the opinion that history does not repeat itself but rhymes at times. I most certainly believe the economy (and real estate markets) is cyclical and that peaks and troughs are caused by the irrational views of the many.
As I stated earlier, we do not believe we are at the peak. We take this view because the national and state unemployment numbers are low, but haven’t yet accounted for all those who gave up and are just coming back looking for employment. Further, we do not see any obvious wage inflation. We see a majority of large and small companies who have been very conservative about their head count and space needs, which is and will continue to be supported by improvements in technology. While we are keeping our eye on the exuberance in the technology industry, we do not see the same parallels to the tech bust of the early 2000’s (as of today). However, we are focused on the risk, especially in certain markets where tech is the main driver of absorption for office, multi-family and industrial.
When I am pressed for answer of what inning we are in, I often say “it’s the seventh inning..but remember, if it rains unexpectedly, that’s a complete game and you don’t get those last two innings.”