I generally try to avoid blanket statements such as this, but I'm confident I will never invest in the following two types of real estate:
1. A Speculative Development Project
I know, I know some of the most successful real estate investors in the world have made vast fortunes and built empires through development. I just won't be one of them. Right or wrong, here is my rationale:
- Development is all about timing and I'm not clever enough to consistently time the market over an entire investing career. Often the best time to build is when the market is in the gutter and development doesn't "pencil" (i.e. the numbers look awful). If you start to build when the market is on fire, you'll often miss the party before you finish construction.
- Developers often have to "land bank" to wait for the right time to build. The holding cost of land creates a negative carry investment, which eats into the project's final returns.
- The entitlement and permitting process is expensive and tortuous. Get out your checkbook, because every consultant and city agency is going to have its hand out. The EIR (Environmental Impact Report) alone can wreck a pre-development budget (traffic study, wind study, etc.) and everything takes 2-3 times longer than your "most conservative" project timeline.
- Too much construction / execution risk. One failed development can crush a company's reputation and balance sheet; erasing years of positive returns. Why not let others develop and just wait for a market dip to buy buildings below replacement cost?
2. A Suburban Office Property
I probably wouldn't be able to sleep at night if I owned a leveraged office property outside of a major city. Here's why:
- Insufficient and Difficult to Predict Tenant Demand. National suburban office vacancy rates already range from 15-20% and now more Millennials are opting to work in the urban core. This is a scary trend for suburban office investors.
- Costly Leasing and Ongoing Capital Expenditures. While each market and lease negotiation has its own quirks, an office landlord is generally responsible for tenant improvement allowances (cost to build tenant's space), which can run between $20-$40 per square foot. So on a 5,000 square foot office suite the landlord might front $100,000-$200,000 in construction costs building out a customized office suite.
To give you an example of how tenant improvements can put the landlord in a tough position, here is a landlord scenario from the credit crisis:
3. Suburban Office Investment Horror Story
- Credit crisis hits – a large suburban office complex loses its major tenant, a now defunct regional law firm that took up 60% of the building's rentable square footage.
- The space sits vacant for TWO YEARS as the landlord waits for another professional services firm to take the existing office improvements (lots of large private offices, wood paneling, bookcases and file cabinets everywhere).
- Landlord capitulates and finally decides to demo the existing improvements in order to show the potential of the space to a larger range of tenants. The landlord also spends over $100,000 on a speculative tenant build out (showcase unit) of a vacant suite.
- After months of negotiation the landlord finally lands a tenant, a start up company (huge credit risk, but the owner was desperate at this point) and then pays the tenant's broker and his leasing broker a staggering amount of money in commissions.
- Speculative build out is demolished – $100K+ gone – to accommodate the new tenant's open space plan. Landlord is forced refinance to pull equity out of the property to fund tenant improvements and modernize the building elevators (a condition of the new lease).
Yikes...no thank you.
While there are certainly exceptions, the capital requirements of tenant turnover coupled with excessive vacancy during recessions are not worth the potential returns of suburban office investments. Personally, I prefer investing in assets that kick off a lot of fairly predictable cash flow, with minimal ongoing capital requirements. This is why I love multifamily real estate investments.
Multifamily Investments Are Far More Capital Efficient
Turning an apartment unit often means a patched wall or two, a new coat of paint, a carpet cleaning and boom...ready to release in a day or two. With mobile home parks – my favorite real estate investment – it gets even better as you're only leasing land. Last time I checked, land doesn't require much in the way of ongoing capital. Furthermore, mobile home park tenant turnover is incredibly low (often 10-20% per year vs 50%+ for most multifamily properties) due to the high costs to transport a mobile home.
Multifamily assets require significantly less ongoing capital than your typical suburban office investments and, I would argue, offer investors far superior risk-adjusted returns vs. speculative developments. Therefore, if you happen to catch me investing in a speculative suburban office building 20 years from now, please slap me.
This article is Copyright 2014 BiggerPockets, Inc
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