Developing a Legacy Asset in a Denver Submarket

When searching for opportunities for my clients, I like to look for areas with some external economic drivers that will attract, eventually, commercial real estate investment. The process typically goes like this: small development forces emerge, residents begin to recognize the changes and speak to their family and friends about the changes. The sites are usually resident-centric, but as the word spreads and more businesses start up, the neighborhood becomes a destination for others. Take Tennyson Street, for example. Six-years ago it was a Business Improvement District (BID). This designation and the investment that followed cleaned up the neighborhood and attracted retail shops and restaurants. Tennyson went from a “scary feeling” place to a good place. Today it is packed on weekends. Today no one speaks about that scary place. It is recognized for its characteristics as a destination. It is close to downtown Denver, has great road access, has new residential construction, new restaurants, new sidewalks and streetlights. It is a place to stroll in the evenings.

I have identified these types of opportunities in Denver by walking the streets, observing, and speaking to the neighbors and business people. I accumulate my learning and take it to another neighborhood. I believe that one must have faith in the process and the natural evolution of the neighborhood.

I advise my clients to use a seven-year planning horizon. I have no crystal ball, but the seven-year period seems to cover potential swings in the market. They can always exit sooner, or hold for longer, even forever, but a conservative plan like seven years seems to work. A lot depends on your required capitalization rate. As competition heats up for the acquisition of properties, those high cap rates become harder to find.

An 8.5% Cap Development in a Historic Denver Metro Area?

In the Denver commercial real estate and development market are there 8.5% caps out there? The answer is, “maybe.” Let’s examine the process to discover if they are out there. First of all, you must understand some basics. How do you calculate the cap rate and why is it important?

Net Operating Income (NOI) = Capitalization Rate (Cap Rate) x Value (V)
Cap Rate = NOI / V
Cap Rate = 8.5%

The cap rate is important to you as the investor for several reasons:

  1. It provides a common basis for buyers and sellers to negotiate price (It’s easily understood by all)
  2. It allows investors to discriminate between investment options
  3. For the assiduous investor, cap rates can form trends in a particular area, further guiding investors in their decisions.

The Denver Metropolitan Area Market

In the Denver metropolitan area there are many neighborhoods where investors have spotted these trends, made their investments, built their developments, and moved on to other emerging market segments. As they do this the cap rates available in the market begin to decline. If your required return is 4-5% and your planning horizon is 20-years, you can probably find deals relatively easily. The higher cap rates will be harder to find, but not impossible.

And here is why.

Global Trends

There is a global trend toward the creation of megacities, created by the inbound migration of rural populations to urban areas. It is happening on every continent and in every country. In addition, there is urban-to-urban migration within these countries, including the US. Within metropolitan areas, there are population shifts that are emerging. Suburban and ex-urban movements back and forth happen daily. Denver and Colorado, for that matter, are no exceptions.

The key for the commercial real estate investor is to identify the trend before others. Often, there is a paucity of data to support your decisions, comps may not be available; you may have to trust your gut or use other data.

Urban planners have known for decades that creating attractive “urban cores”, no matter the size, bring in new residents and the investments necessary to support them. These urban cores are really just hubs in a much larger network. These hubs are connected by transportation infrastructure, adequate housing at “reasonable” costs (reasonable for the area), retail establishments, offices, warehouses, schools, entertainment venues, hospitality infrastructure, and healthcare facilities. Each hub must compete with other hubs to establish its relative attractiveness. Its “fitness for use” for the residents and businesses must be better than the other potential hubs at any one point in time.

Where Are the Opportunities?

Why is this seemingly arcane description of an urban environment important to a small commercial real estate investor? Because it identifies where the opportunities are and where they are emerging. Everyone in commercial real estate in Denver knows about RiNo. The land there has gone from $30 per square foot (PSF) five-years ago to over $200 PSF today.

LoHi and LoDo have gone through a similar evolution. Now we see Sloan’s Lake area feeling the pressure with the old St. Anthony’s site skyrocketing upward. There are many emerging areas and established areas that are, or can become, important to commercial real estate investors and they include: Stapleton, South Gaylord Street, Tennyson Street in Berkeley, Old Town Arvada, and maybe Wheat Ridge, Aurora, DIA’s Aerotropolis, and Westminster.

How does a small commercial real estate investor capitalize on these opportunities? By understanding the economic drivers behind potential development.

My Case Study

For example, I had been working with an investor for a year showing him potential deals once per week to no avail. I showed him a property listed on Costar in a sleepy urban enclave that had no recent comps for our development ideas. Over the last three years it has become a booming suburban development area but for many decades after its founding it was a sleepy outpost for the surrounding farms. I convinced my client to look at this property located in the center of what would become a thriving neighborhood core. Today it is the site of a future 36,000 square foot mixed use development with rents at $32 NNN which will produce an 8.5% cap rate.

This was the first deal we closed together. During that time, he gained confidence in me as he watched me work with other clients on the sale of their assets, manage 1031 Exchanges, and townhome developments. He saw that I was not working for just a paycheck, but in the best interests of my clients. He liked that I was a boots-on-the-ground, down-in-the-trenches member of the development team and when I showed him the detail about the activity in the neighborhood, he trusted it enough to make the investment.

The Development Site

The site contained an under-utilized concrete block building with many unregulated additions and modifications. It served the purposes of the current owner but had little utility for a development site. It was located amidst the town’s self-designated historic buildings.

Many asset owners located nearby had chosen to voluntarily designate their properties as “historic.” This designation gives them fiscal and other benefits that result in the preservation of their properties. Our target property was never designated as such and, as a result, was available for demolition.

When I first reviewed this property listing on Costar, I immediately searched for rental comps for condo and townhome developments and found little of value. I knew it was going to be difficult to convince this sophisticated investor that this property would fit his portfolio. Despite the lack of comps, my instincts, or my gut, told me that higher value uses for properties were inevitable.

This site is in many ways similar to the many small neighborhood districts around Denver that
have become destinations in their own right. In these areas the retail operations are initially supported primarily by the neighborhood. As the word spreads to friends and families, the site becomes a destination and draws traffic form the entire metropolitan area. I saw a small central business district neighborhood with a great feeling. It was quaint, with lots of pedestrian street traffic, and, of course, its own unique historic character.

The Offer

Although my buyer did not know what he would eventually do with this property we made an aggressive, full-price offer ($1,950,000) with 30-days due diligence and a closing 10-days later.

Our due diligence included a soils test for the foundation design of a future building, a Phase 1 environmental review, an asbestos test of the building, and a survey of the property to reveal any easements. The environmental report is basically a research paper of the chain of title of this property and those nearby. The search is to find if, in the chain of title of these properties, there were uses with potential residual ground contamination issues.

Getting to Closing

The soil tests were fine. However, the survey showed a city sewer main running across the back of the property that eliminated 7000 sf of building space on the property. The Phase 1 report was clean, but the asbestos report was hot and resulted in an abatement cost of $70,000. This and the loss of buildable area because of the sewer line resulted in a final price, after renegotiation, of $1,780,000. It took eight months to get to closing, but the physical issues were resolved in two months. The rest of the time was spent with the municipality.

At the time, the town had loose guidelines on what you could build. The City Council and the city’s economic development group claimed the site was historic. But it was not. Their design guidelines and zoning code allowed for condos with a retail ground floor. My client had the initial idea to have a retail ground floor with six luxury condos on top with unobstructed views of the mountains. The town said no. It took 2.5 years to finish the negotiations and today a new building with 5,000 square feet of retail on the ground floor and 36,000 square feet of office space on the two floors above will be ready in September. It is renting at $32 NNN, producing a
8.5% capitalization rate, if they were to sell it. However, this property is likely to be a legacy asset. They will hold it forever.

In retrospect, the municipality was not prepared to examine and approve the designs. The city was reluctant to move forward, although the need for this type of development was apparent. If we had not felt so secure about the underlying economic drivers of the area this deal would not have closed. Out guts told us to go forward.

The Numbers

  • $1,780,000 purchase price
  • 8.5% cap rate.
  • $11-12m total cost.
  • $220 per square foot for construction cost.
  • Net income of $1,150,000 per year. ($32 triple net) (10% Cap, maybe)

A typical investor with a 7-10-year planning horizon would have leased it at $30 triple net and then unload it in a 1031 Exchange into another asset. With $1,150,000? net operating income the property would sell for 5.5% cap rate, or $15.5 million, a $5m profit.

It’s that good because of the original risk the buyer assumed. He had the risk tolerance that was required. He trusted me although I had no comps to support my opinion and relied upon my instincts. If there had been lots of good data on similar properties there would have been competition to purchase this building. Normally, an investor would like to build to a 7-8% cap rate and sell at 6% cap rate which would result in a $2m profit.

As income from the rents increases and as the surrounding properties increase in value the return could be higher. The $15m valuation is on income alone, not the asset appreciation.

Conclusions

Why did he trust my instincts? As he told me over burritos at lunch one day, he sees me as a developer, not as a broker. He has seen the multifamily developments I have done with other investors and he has seen me on the ground doing the work.

I brought him possible deals every week for a year. He knew I was not in it for just a paycheck. I have always worked to meet his needs, not mine. Typical brokers want a commission and then get out. For me, it is always what is in the best interest of the client, buyer or seller; there is never any discussion of my compensation until close to closing.

Take-aways:

  • Know your risk tolerance
  • Know your investment goals and your planning horizon
  • Understand what could drive value in a given area

Final Thoughts

It might appear that commercial real estate transactions are complex and you are wondering, “How do I get started?

  • First of all, commercial real estate transactions do not have to be complex. If you want to know how to get started, call me. Let’s have a coffee. There are deals out there for all levels of sophistication and budgets.
  • Don’t read too much. Some articles over simplify; others produce paralysis by analysis.
  • Commercial RE sounds more intimidating than it needs to be. You don’t have to be a sophisticated investor to have success.

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