Now is the phase of the CRE cycle when repositioning success stories are born. Imagine this column five to ten years from now: we’ll be reading about a property that was purchased for a song, underwent transformative repositioning, and achieved an impressive return upon sale. That deal, and others like it, are crossing someone’s desk right now. Unfortunately, these deals come with huge task lists to be worked through during the underwriting process. Rather than becoming overwhelmed, savvy CRE investors leverage due diligence advisors to bolster in-house acquisition teams and quickly put brackets around the “wild card” items that could sour projected returns.
Here’s a scenario: a property, possibly a hotel or retail building, was performing at one time but has recently suffered a sharp decline in cash flow. Maybe the cash flow is zero, and the building is sitting vacant. The broker has limited knowledge of the building systems and the building is to be sold “as is,” without any of the negotiations that are so familiar to other deals. But the location is great, the demographics are promising for a variety of future uses, and the asking price is well below replacement value. There is a at least one vision of what the repositioned property could be that would make the project a winner.
Assumptions for the big, important details—like asking rent, uses, occupancy, market absorption, finance carry costs (short and long term), post lease-up valuation, permanent financing, project horizon, exit, etc.—are right down the fairway for seasoned CRE finance teams. The deal “pencils.” It looks like there will be a healthy return. On the other hand, budgeting for renovation costs, understanding the outlook for building systems, and avoiding large scope deviations—those significant unknowns, the “wild cards” in a repositioning project, are best addressed by architects, engineers, and construction experts that are accustomed to functioning within the timelines of a Purchase and Sale Agreement.
Identifying and quantifying physical condition wild cards can be very helpful in a real estate model. Using a Property Condition Assessment (PCA) to determine which building systems you should expect to replace, repair, or reuse, and then compiling the preliminary costs for these systems can be critical to the go/no-go process. Tally all these items up and you have your preliminary project reposition budget. If all goes as planned, or at least close enough to plan, you’ll have a revenue-generating property again and the project will be deemed a success, right?
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The problem is, you’re still holding a wild card. A big wild card. The goal is to model the whole project–that includes the whole construction project–and the components need to work together. Complications across building systems and trades need to be accounted for; without them, the model is no good.
A detailed estimate for construction in an executable form, with a low probably of material change orders, is not feasible until plans, ideally bid plans, are prepared. It is extremely difficult to plug in a proposed reposition Capital Expenditure budget into a deal proforma or Discounted Cash Flow model when all you have is a vision. To reach the bid plan stage and come up with a “real” construction number, developers invest considerable time and budget in program development, conceptual planning, design development, permitting, and so on. When contemplating an acquisition, there is neither the time nor the budget to reach this point. So what can you do?
When examining detailed cost estimates based on approved bid plans, many experts recommend that you carry a 15% contingency. What contingency should be carried when you don’t have any plans? This is a hard question. In our experience, the answer lies in determining the largest budgetary line items first and working through your program assumptions, while keeping a mindful eye on the overall project. Ask your due diligence consultant for a PCA with a scope modification to incorporate a building repositioning. With this scope modification, you can get answers to questions like:
- What are some options for reconfiguring the utility metering, so the tenants pay their own utilities?
- Will this cooling system have enough capacity to serve the repositioned building?
- What is a good system to improve the indoor air quality of this building
- How much should we carry to adjust the height of all the sprinkler heads?
- Will the elevator hoistway be large enough to accommodate modern elevators?
- What modifications will be needed to meet ADA accessibility standards?
- Does this building require a structural seismic retrofit?
- Does it make sense to add more insulation to the roof when we are replacing the membrane?
You can even pose open-ended questions, like this developer favorite: “Here’s what we’d like to do. Do you see any other issues we haven’t accounted for that will need to be addressed?”
This scope might include services like municipal research into the building’s history, 3D imagery that can be used later to generate accurate as-built plans, as well as insights from subject matter experts in fields such as Mechanical Electrical & Plumbing (MEP), Fire Life Safety (FLS), Industrial Hygiene (IH), Elevator, Façade, Roof, Structural, Site Civil, and Geotechnical engineering. An experienced due diligence advisor can do more than provide scope options; they can discuss your project with you and help craft a scope that maximizes the insight you gain in the limited amount of time available to advance your deal.
Architects and engineers that live in the world of evaluating buildings for future capital planning and overseeing active construction projects on behalf of those that provide construction financing are particularly well suited to this task. Given the time and budget constraints, this is one of the best sources of information for the developer evaluating a repositioning project. This upfront investment, often a negligible amount in the context of total project cost, can easily provide exponential returns upon project completion and help avoid unforeseen problems that hurt returns and frustrate investors.