By Jerry Rotunno, Senior Vice President of Commercial Real Estate at Associated Bank
Businesses and consumers are more confident than in recent years. Crude oil prices are down, giving a $100 tax free bonus to every household budget. Cheaper energy makes our Midwest manufacturers more competitive relative to China and other emerging economies. More manufacturing activity is moving back the U. S. Retailers are now refining their omni-channnel strategies that recognize that the internet can boost sales and efficiency. They are adjusting store sizes and logistics strategies. It is not surprising that both the University of Michigan Consumer Sentiment Index and the Chicago Manufacturers index are higher than they have been since the recession. This confidence affects our industrial market “coming and going”, that is on both ends of the supply chain. We are seeing more demand for warehouses as product is coming out of our factories. We are also seeing more demand for new efficient distribution centers as the same product is going the last mile to the consumer.
The developers, bankers and investors of industrial real estate share in this economic confidence. The participants in Emerging Trends in Real Estate survey for 2015 rate industrial as the most desirable property type in need of development, especially for primary markets like Chicago. In early 2013, I wrote the following in this column about speculative industrial development: “The key is to show a user will lease the project within a short time after completion”.
Today, there is enough leasing velocity on successful speculative developments that some property investors are comfortable that the lease-up will occur in a predictable manner after construction is completed. These investors are willing buy the property at construction completion without leases. There is a shifting of the leasing risk on speculative projects from the banks and developers to the end investor. Thus a new model has emerged for speculative development; let’s call it the “Build-to-Sell”.
Investors willing to acquire buildings without tenants are only looking for the “Best of the Best”. They want buildings with features that are hard to duplicate such as 32 foot clear height and trailer parking. They are only interested in submarkets where developable sites are scarce and expensive such as O’Hare or I-55. This model has not replaced but supplemented the traditional speculative construction model, in which the project is not sold to the end investor until it is completed and 100% leased. The question for a developer becomes: When to sell? At completion or when occupancy is stabilized?
The traditional development model still has its advantages. The principal advantage is price. When a project is placed on the market and is 100% leased, the risk to the buyer is minimized. The rental rate and lease term is known for each tenant. The timing of the cash flow is defined by the leases. Cost of tenant improvements is in the purchase price. All these factors attract a maximum number of bidders for the property which results in the best sales price. There are disadvantages as well. Bankers are sharing in the leasing risk with the developer. To entice a bank to make the construction loan, the capital stack, that is the debt and equity combination that adds up the total cost to construct, requires 35% equity for the banker to make a 65% of cost loan. For a $20,000,000 project, that computes to $7,000,000 of upfront cash equity before the first loan dollar is funded. Few developers have that level of cash. The few that do are not willing to commit that much to one project. When we are at a phase in the demand cycle in in which one can find simultaneous opportunities across multiple markets. Developers are spreading equity investment over several projects at once.
The solution is to bring in outside investors. Generally, these investors will contribute 90% of the equity required with the developer contributing a more manageable 10% of total equity. These equity investors get a preference when distributing the profits on sale. A larger equity piece requires a larger preference. This return does not come until the sale occurs. It can take 24 months to lease a project plus nine months to build it. So the return of equity to the developer can be nearly three years. The preference on such a high level of equity over several years results in a compounding of the equity return. Hopefully, the rents achieved and timing of leasing are such that the sale price can pay the equity return.
The Build-to-Sell eliminates some of the disadvantages of a traditional speculative project. First, with a firm contract prior to construction beginning, the capital stack will require less equity. While a traditional speculative deal requires 35% equity, a pre-sold deal will require as little as 10% (plus a pledge of the buyer’s earnest money). Second, the developer can recycle his equity quicker. With a nine-month construction period and followed by a sale, the equity is returned in less than one year. Also, with less equity, the developer can eliminate the outside investor and use his own cash. Thus there is no need to pay a preference and share the return on a successful project. Warren Buffett uses the analogy that it is like spreading the same amount of cheese on a smaller pizza. The pizza is richer and cooks faster.
The disadvantages of the Build-to-Sell mirror the advantages of the traditional speculative structure. Fewer investors want to take the risk of an unleased property. The timing of the leases, the amount of rent and the cost of the tenant improvements is unknown. Also, those investors have to bid on the project nine months in advance. Many investors prefer to know the market conditions when they invest. Some drastic changes can occur in nine months, so there is more risk to the investor. We saw significant shocks to the financial markets in the first nine months of the year in 2001 with nine/11 and again in 2008 with the Lehman Brothers bankruptcy. The maximum price cannot be achieved because there are fewer bidders and those bidders need to be compensated for the additional risk.
With distinct advantages and disadvantages to the Build-to-Sell and the conventional speculative structure, there is no universal answer as to which is preferable. One point is hard to dispute: if a developer is going to sell upon completion, it is best make this decision before starting construction. If a deal starts as a purely speculative development without an end buyer identified, the equity requirement is higher. Selling the project after the equity is contributed but before occupancy stabilization, has the disadvantage of a higher equity requirement (35% of cost) and the disadvantage of not obtaining a maximum price because a building that is not leased will have fewer bidders.
The decision depends on the leasing market and other opportunities the developer has. Perhaps the best approach is to have a blend of both methods. The buyers of these properties have a global perspective on economic demand, but they may not be as attuned to a specific submarket as the developer is. In this case, the developer is more comfortable with leasing risk than the buyers and should take on the risk. The size of the speculative deal is another consideration. In another case, larger projects have proportionately higher risks relative to a developer’s financial resources. Pre-selling a larger deal may be a way for a developer to take on a larger project without overextending his financial condition. His lender would prefer this. Finally, if the developer has more than one project under construction at the same time, pre-selling one and holding the other through the lease up phase makes sense.
The confidence that developers, lenders and buyers have in the leasing activity now gives developers a choice in the financial structure of a speculative project. Diversifying the risk across both structures and across time is a prudent way to manage the risk of these projects.
Jerry Rotunno is Senior Vice President of Commercial Real Estate at Associated Bank in Chicago. This article was written with assistance from Tony Pricco of Bridge Development Partners and Dan Fogarty of Conor Commercial Real Estate.