Value Investing and Commercial Real Estate

Several months ago I proffered a question for reader contemplation. It went something like this: "Can the concept of value investing in securities be applied to commercial real estate investment properties?" If you recall, that question emerged for me after reading Michael Lewis's book The Big Short. Lewis highlighted how value investing was one strategy that brought certain individuals to "short" the sub-prime mortgage market and make several billion dollars along the way.

In our last post I asked you to provide me with some feedback on the above question. I waited and waited through blizzards and wind chills and finally tornados to conclude that you weren't going to respond. Perhaps I'm pulling the plug on the dialogue a little too quickly, but I figured four months was enough time for my seven followers to weigh in. But alas, you haven't. So now you'll have to endure (if you're still reading) me answering my own question, which is obviously why I asked it to begin with.

Commercial real estate investment properties, particularly net-leased investments, are typically evaluated on what is essentially an income approach. Buyers of these assets typically evaluate capitalization rates when comparing one asset to another. Sometimes investors will look at the underlying demographics or other specific market factors as a way of putting the investment under a three-dimensional lense. But most investors will fixate on the cap rate or cash-on-cash return or IRR which still by-and-large relegates the real estate to the one-dimensional world of paper investments.

There are undoubtedly many concepts that could be applied to the question of value investing in commercial real estate. I've come up with three that I think are worth mentioning. These include:

1. Cost Per Square Foot
2. Residual Value
3. Adaptability

This list should not be considered exhaustive and as we'll see these three factors are very interrelated. Some can be quantified; some cannot. We'll look at them in order.

Cost Per Square Foot
Perhaps no other metric gets at the "book value" of real estate than the cost per square foot (PSF) of the asset. This is probably the only factor of the three that can be objectively known and quantified. It can be measured against other assets. It may and usually has some reflection to the underlying land value of the improvements which should have some correlation to market factors such as traffic counts and demographics. It may reflect the building's age but does not have to. It may only reflect the rental rate of the lease governing the property. Too often when evaluating net leased investments, we find extremely high costs per square which are solely attributable to the income approach. These costs may have no correlation to the building's true value and are only reliable as long as the tenant continues to pay the corresponding rent. Investors should use extreme caution when paying exorbitant costs per square foot. They would be wise to evaluate how closely the underlying lease rates track with market rents in the area. If they are double or triple the market, the investment's value may not hold during its useful life. This leads us to our second factor--Residual Value.

Residual Value
The residual value of a real estate investment is simply the asset's value once the original tenant is no longer occupying the space. Once the tenant, be it Walgreen's or Dollar General or whomever, vacates the space due to relocation, closure, lease expiration, etc. questions surface such as What is this building worth to another owner/user? Or, For what amount of rent can I re-tenant this asset? These questions are predicated on the asset's residual value, which may or may not have any correlation to the property's original lease rate and acquisition price. Investors would do well to look into the future to project the asset's residual value in the event the tenant eventually vacates the property. This may seem insignificant when there are 20 years left on the lease, but any long term play should account for the eventual certainty that the property will one day be vacant. While the residual value does not have to be the same or more than the present day acquisition price, great care should be taken to ensure the residual value is not 1/3 or 1/2 of the original acquisition price. This can occur when the property's current rental rate is way out of whack with the market.

Adaptability
The final concept we'll look at is what I call Adaptability. The question we want answered here is what to do with the asset once it becomes vacant?  A popular issue within the worlds of Architecture and City Planning is that of Adaptive Reuse. Adaptive reuse contemplates how an older building which was utilized for one purpose during its early life can be modified to house a completely different use during its later life. When we think of adaptive reuse we think of warehouses turning to lofts or massive train stations being converted to museums, shopping centers, or office buildings.

Our concept of adaptability with investment properties is similar to this larger concept of adaptive reuse. How simple will it be for your asset to house another similar retail tenant if your first tenant leaves? Are there peculiarities or idiosyncrasies with the building that would preclude 90% of other would-be tenants? If so that might be a red flag. Adaptability obviously carries with it both physical and financial components. Many buildings might be vanilla boxes capable of housing other retailers, office users, etc., but they may not financially accommodate many users. The financial component points us back to our concepts of Cost Per Square Foot and Residual Value.

Perhaps the best illustration I can think of that brings these topical issues to reality is to look at the case of a single tenant property leased to Starbucks.  I had a Starbucks deal cross my desk this morning. I'm sure it's a fine property but the asking price was well over $1.5 Million while the size was only about 1,850 square feet on one acre. The investment's NOI was over $120,000.  The resulting cost per square foot was over $854 while the tenant's rental rate was almost $66 per square foot. While Starbucks is a great tenant, this deal does not fare well when evaluated against our three criteria. Its cost per square foot is some three-to-twenty times higher than that of properties leased to other credit tenants. Further, it is doubtful a Starbucks residual value would ever come anywhere close to that of a local market when the rental rate is $66 PSF. And if these two issues were not enough, adaptability comes into question. Restaurant properties rarely can be used for anything besides restaurants. Starbucks might contain even more specialized features than a typical restaurant (think limited seating) which suggests it would miserably fail the adaptability test. Perhaps one could get comfortable with these issues if we were talking a 30 year lease, but this deal's lease had only 6.5 guaranteed years remaining. Any purchaser there might be asking our questions much sooner than he or she should have to.

Hopefully we've given you a few things to think about. Perhaps you've thought of something we haven't. If so, we'd appreciate a comment. But this time we're not going to wait on you for four months....