Scratch That, Start Over
Converting commoditized office buildings are getting a lot of headline coverage these days. Vacant office buildings in major cities are turning to luxury apartments or middling multi-tenant office buildings that everyone is scratching their head about converting to condos. Developers wondering how deep the floor plates are and how they can create air ventilation has become a fun cocktail conversation for those that make this their profession. The developers’ imaginations are bulging but the spreadsheets are blinking red. New York times covered this a few weeks ago as to the challenges to make the math work and yet Bisnow and the Real Deal continue to fight the optimistic city-building narrative around lack of affordable housing as the motive to drive conversions. No one is wrong, it just comes down to numbers and how the highest and best use reconciles with spreadsheets and seller expectations.
As the old saying goes, the three most important factors in real estate are location, location and location. So when we look at what’s happening with well located office buildings and the challenges of converting one use to another, we are left looking at the land value. A developer has a breakeven threshold whereby it becomes the most profitable scenario to acquire a property with its improvements (aka a building), demolish the structure and start over to build from a blank canvas for a new development. The breakeven is heavily predicated on the purchase price. I’m not a real estate analyst but I learned from the history of Southwest Airlines that if it doesn’t make sense on the back of a napkin then it probably doesn’t make sense at all…
A developer should be indifferent in these two scenarios:
Scenario 1 [Convert it]: Acquire a 100,000 square foot vacant class B office building for $30MM, put in $15MM to convert it to 75 apartments and sell it for $700,000/door for a total sale of $52.5MM. That’s an unlevered return of 16.7% on your investment.
Scenario 2 [Start Over]: Acquire a 100,000 square foot vacant class B office building for $20MM, demolish it and build 75 apartments ground up for $333,000/door (~$25MM) and sell it for $700,000/door for a total sale of $52.5MM. That’s an unlevered return of 16.7% on your investment.
There are many other factors at play here but the point is that you might not care as much about how you get to the end result as long as the inputs in the math get you to the same or better outcome. Of course there are no two exact situations in real estate and that’s what makes it fun but we’re seeing the market get to the point where acquiring a building for one use and then demolishing it to start over might make a lot more sense on a grand scale than trying to convert older uses and digging up the skeletons of its past. That’s what happened with this $22mm office teardown in Orange County.
There’s a lot of things in life that make you question whether you should keep toiling and reworking the inside or if you’re better off scratching it, recognizing the proverbial land value of your time, energy, skills and choose to start over. Maybe this is all a metaphor for life decisions in the end.