Most underrated fundamental in commercial real estate: the building life cycle
----- Every building has a life cycle -----
1. Land and/or unleasable property
2. Capital investment
3. Leasable and valuable
4. Gradual degradation
5. Obsolete and/or deferred maintenance
----- Capital profiles -----
These cycle stages create the need for differentiated capital profiles...
Core:
-- Income focused
-- Low leverage (< 50%)
-- 7-9% IRR
Core plus:
-- Income focused w/mild value creation
-- Incremental leverage (< 65%)
-- Incremental leasing
-- 8-11% IRR
Value add:
-- Asset repositioning
-- Meaningful leverage (60%+)
-- New leases
-- 15%+ IRR
Opportunistic:
-- Development or complete reconstituting
-- Meaningful leverage (60%+)
-- Significant levels of uncertainty (cost, leasing, sale value)
-- 18%+ IRR
[Note: the characteristics above (e.g., return thresholds) are meant to be generally indicative and vary across specific investors and cycles.]
----- Capital fits with cycle stages -----
The capital profiles outlined above tend to fit specific stages of the building lifecycle.
-- Opportunistic capital creates an income stream (0 to 5 years)
-- Core capital clips coupons (next 10 to 20 years)
-- Core plus/value comes preserves income (20 to 80 years)
-- Opportunistic capital creates another new income stream.
----- Case study: 995 Market Street -----
Recent headline: "LNR buys San Francisco office building for 11% of 2018 price" (The Real Deal)
Doom loop narrative:
'San Fran office is down 90%'
Reality:
-- A small building sold for $62M to a 1031 buyer 8 years ago
-- The building was 108 years old when it sold
-- The prior sale (in 2013 at 105 years old) was for $17M
-- The sale before that (in 1997 at 89 years old) was for $3M
-- The building's value grew by 3% per year between 1997 and 2024
Key takeaways:
-- This building has been teetering with extinction for at least 20 years.
-- Headlines exist to tell stories that appeal to human nature.
-- Headlines aren't generally helpful in understanding investment realities.
-- Big losses occur when capital misaligns with building cycle stages.
----- Welcome FastTrack 16.0 -----
We will kick off the next cohort of FastTrack tonight by covering the building lifecycle.
Why do we start with the building life cycle?
....because it differentiates real estate from other asset classes.
....because it defines the need for capital in our industry.
....and because our industry revolves around capital.
The course gets a lot more complicated, but so much of the complications tie back to the simplest reality in real estate: buildings (like people) get old.
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