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By Stephen T. Hosch
The commercial real estate market has always been cyclical, ranging from strong growth periods to extremely overbuilt conditions. During the last cycle, the market shifted from a commercial development boom in the late 1980’s to an extremely overbuilt condition by the early 1990’s, before rebounding again in the mid to late 1990’s.
In the early 1990’s, overbuilt conditions in the market resulted in numerous bank foreclosures and "fire sales" (deeds were transferred in lieu of foreclosure), with the former owner losing most, if not all, of the equity. The lenders accumulated a large, unwanted supply of real estate. Most of these properties had high vacancies, deferred maintenance, and/or functional obsolescence. Those buyers who had the financial resources to meet the equity requirements f the initial purchase of these properties and the carrying costs prior to reaching stabilized occupancy (the new mortgage payment, leasing costs, curing deferred maintenance, etc.), realized significant capital gains by selling these same properties prior to 2000.
Ten years later, as we find ourselves in the overbuilt phase of yet another cycle, few distressed properties are going through foreclosure or being sold, in lieu of foreclosure at deep discounts when compared to the last market cycle. The primary reason for the lack of a buyer’s market within the last few years has been the ability of the property owners to refinance at record low interest rates in order to "ride out" the current recession. Those few properties, with high vacancy rates or sitting empty, that have been available on the market have not transacted at the record low prices one would expect. The sellers are more patient, creating large disparities between the asking price and actual bids.
In light of the limited opportunities for buyers looking for significant equity growth by purchasing troubled properties, other avenues are being pursued. These generally require a greater level of buyer sophistication in order to realize even the gains that were considered to be at the low end of the levels experienced by sellers of repositioned properties in the late 1990’s.
Four creative opportunities have been identified in this article that may provide higher returns in the current environment. They are:
Redevelopment of Obsolete Properties
As the Twin Cities Metropolitan Area continues to expand, commuting times have increased exponentially. Obsolete and/or underutilized properties possessing the proper demographics as well as general locational and site characteristics can become candidates for redevelopment into single- and multi-family housing sites or new commercial developments.
Numerous successful redevelopment projects can be observed throughout the metro area. Of particular note are: the new Best Buy headquarters in Richfield, the new Tarter store and headquarters in downtown Minneapolis, Medtronic’s new world headquarters on the former 100 Twin Drive-In Theater site in Fridley, the Quarry shopping center off of I-35W in Minneapolis, and the new Science Museum of Minnesota in downtown St. Paul.
Demolition of existing buildings, soil correction, and other site preparation costs can make redevelopment very costly. In many cases, redevelopment is not economically feasible without some form of public assistance. Buyers and developers of these sites are at a competitive disadvantage considering the total site development costs for redevelopment projects. A general knowledge of the public development tools currently available is crucial to successful redevelopment. Tax Increment Financing (TIF), tax abatement, development grants, public financing and others are common.
In-Fill Development
In-fill sites are still available, although they are becoming more scarce. The question that must be answered is: "Why has the site not yet been developed?" Poor soils, on-site contamination, title problems, challenging topography, zoning constraints, and properties that have been developed on odd-shaped oversized lots are all possible answers. For example, 25 to 30 years ago, as the rest of the neighborhood developed, soil correction costs of a particular site were perhaps too high to justify its development. However, as strong demand for in-fill sites has driven up prices for ready-to-build sites, correction of the poor soils may now be economically feasible. Depending on the impediments which exist, a current cost benefit analysis may provide an opportunity for the informed buyer. Two very successful in-fill developments are the spec office building developed on the southwest quadrant of Highways 62 and 169, and the single-family residential developments on shore-line cul-de-sacs carved out of large estates along Meeting Street in Minnetonka.
Repositioning of Existing Properties
There are few opportunities providing for significant upside in the current marketplace when buying properties based on existing cash flow and/or use, unless the property has experienced a high degree of functional obsolescence. This may be due to a shortage of on-site parking, poor visibility, and/or lack of windows within a commercial property, or few to no amenities in an apartment complex. By purchasing or leasing adjacent property to cure the parking shortage and/or access problems for the commercial property and adding some windows, a sale of the property upon reaching stabilization can result in measurable capital gains.
An apartment complex that can accommodate new garages, rearrangement of unit mix, new appliances, and cosmetic updates, to better compete within its immediate market, can generate substantially higher net operating income through rent increases and higher occupancy rates.
Conversion of Existing Properties
Sometimes a property reaches a point when repositioning is no longer physically possible or economically feasible. In these cases, either redevelopment or conversion of the existing structure remains. Ultimately, the property has to meet a minimum set of criteria to be considered competitive in the marketplace following a conversion. For example, a turn-of-the century multi-story industrial building located in the middle of a vibrant industrial neighborhood, may possess excellent architectural characteristics for conversion into a residential loft condominium project. Unfortunately, it may not meet the general location and demographic criteria required for a successful residential conversion. However, the same building, located on a river front site in a little used industrial area might provide just the right combination for conversion to a multi-family residential neighborhood. Examples of successful conversions from industrial to residential neighborhoods can be observed in the condominiums along the Mississippi River in downtown Minneapolis’ historic warehouse district, (Northstar Lofts, Washburn Lofts, etc.), in Duluth’s Canal Park area (Hawthorne Suites/Suites at Waterfront Plaza), and in downtown St. Paul (Lowertown Lofts and the new Mississippi Riverfront developments).
The feasibility of conversion versus redevelopment may be very close. The ultimate decision may depend on whether the existing shell can physically be converted and at a cost low enough to provide an adequate return to the developer. The following table explores examples of potential conversions based on a cost-benefit analysis.
As the table illustrates, the first two examples appear to be economically feasible, while the third example does not provide enough profit. The property in the third example will have to experience stronger appreciation in value as a converted residential condominium. Price increases in the value of the condo units will have to outpace the costs after construction in order to be considered feasible for future conversion. Properties like this could easily provide one of tomorrow’s investment opportunities. This article focuses on redevelopment properties, but these strategies apply equally well to other property types for investment purposes. By paying attention to real estate cycles and changes in market conditions, the creative investor may still find opportunities for significant equity growth in today’s market.
