The Market Seen from the Street: Real Estate Development Assets – Sell or Create Value?
Today, I choose a topic that has been giving me food for thought.
Before delving into details, it's important to define what "Real Estate Development Assets" are. In a very "simplistic" way, I consider "real estate development assets to be properties with the potential for appreciation through the alteration of their characteristics.
Perhaps not a completely clarifying definition, that's a fact.
For a better understanding of the type of assets I'm referring to, I'll share some examples, focusing on the residential segment.
Land with development potential - Example: Land that can be transformed into a building or residential complex consisting of a certain number of units (apartments or houses) according to the urban assumptions of the location where it is situated;
Buildings with expansion potential - Example: Residential building located in a consolidated urban center, consisting of 3 above-ground floors, with the potential for expansion by 2 floors and a consequent increase in its Gross Building Area;
Buildings with potential for change of use - Example: Office building with the potential to change its designation for residential use;
Buildings with rehabilitation potential - Example: Residential building located in a historic area, in a state of ruin;
Buildings requiring legalization - Example: Unfinished residential building with the need for legalization and completion of works to become habitable;
Others - Note: If you have other suggestions, don't hesitate to share your opinion;
All the examples presented have a "common denominator." The Real Estate Development Process (Related Article: https://bit.ly/3Y7O55S) will be economically viable if there is a possibility to CREATE VALUE.
What does creating value mean when referring to real estate development? I consider value creation to occur when the INITIAL ASSET VALUE + DEVELOPMENT COST < FINAL ASSET VALUE. The higher the risks and uncertainties associated with the development process, the lower the value of the asset at that moment.
All of this may seem very complex. It is a fact. However, it all boils down to risk mitigation. In my opinion, the value creation process is nothing more than mitigating risks, removing uncertainties from the equation, and increasing the likelihood of success.
To better frame these concepts, I've decided to create a Case Study.
Imagine a residential building, built in the 1960s, registered under Total Ownership and located in the center of Lisbon. Here are the assumed characteristics for this case study:
Land Area: 300 sqm
Footprint Area: 200 sqm
Gross Construction Area: 1140 sqm
Circulation/Staircase Areas: 190 sqm
Gross Private Area: 950 sqm
Outdoor Areas (Terraces and Balconies): 192 sqm
Number of Independent Utilization Units: 12
Mix of Typologies: 2 x T2 + 8 x T3 + 2 x T1
Allocation: Residential
Conservation Status: Reasonable
Observations: Presence of tenants, need for legalizations, and renovation work required.
Table 1 - Building Characteristics
The analysis of Table 1 "suggests" a lot of complexity and uncertainty. Even without knowing the specific assumptions, when we see the presence of tenants, the need for legalization, and renovation work, the usual tendency is to assume the "devaluation" of the property.
In real estate development assets, risks always exist, varying in magnitude and controllability. In theory, the higher the associated risk, the greater the required return for a given investor.
These characteristics are often found in assets held by undivided inheritances. In many cases, heirs may lack experience or knowledge of real estate asset management. For reasons of liquidity needs or simply due to "lack of agreement" among stakeholders, they may choose to sell the property.
Is selling always the best option? In some cases, I believe it is (e.g., when the property's condition jeopardizes its use). However, there are other occasions where this option means "value destruction."
The inheritance division and transmission process can have many points of contention among stakeholders because their needs may not align. Consequently, conditions are created for decision-making to be more emotional than rational.
In these cases, the procedure is generally similar:
Typically, an evaluation (or more than one) of the real estate assets is requested to establish a Market Value.
Then, the asset is put on the market for sale to seek the best offer.
Potential buyers will evaluate according to their specific needs and business risks. Theoretically, there shouldn't be a significant difference between the appraised value and the values of the received proposals. However, "the Market" always has the final decision.
Finally, negotiations are concluded, and the asset(s) are transferred to their new owner(s). The sale proceeds are divided among the heirs in proportion to their ownership, excluding taxes and all costs associated with the sales process.
On average, these processes are never resolved in less than 6 months from the moment stakeholders make decisions.
Even if the option is selling, are there no possibilities to mitigate risks and enhance the Real Estate Heritage?
In most cases, I am sure there are. Risks are often superficially analyzed, with an underlying assumption of complexity that, in reality, could be quite straightforward.
What are the main perceived risks that could affect the asset's value? Existing lease agreements, the need for renovation works, and potential legalization needs for building spaces.
To manage and mitigate risks, it becomes essential to develop a diagnostic analysis that allows creating different scenarios and establishing an action plan for risk mitigation. The Value Creation process begins.
Brief Analysis of Tenants
Let's start by analyzing the occupancy of the building.
We have six vacant apartments in reasonable condition, requiring renovation work to improve habitability and comfort conditions. The remaining apartments are occupied, with rents significantly lower than the comparative market offer. As a comparative benchmark, I chose to adopt the rents established in the Affordable Rent program.The assumed potential rents are based on the maximum rents allowed by typology for the municipality of Lisbon.
We also note the existence of three "lifelong" lease agreements. In theory, these are complex contracts and difficult to resolve unless there is an intention to leave on the part of the tenants.
Lastly, there are three contracts under NRAU (New Urban Lease Regime) , with a fixed term. Normally, in these cases, an opposition process to renewal is assumed.
Despite contractual assumptions and their specified clauses, we are "analyzing" residential contracts. The "associated social issue" should not be forgotten. Common sense and dialogue with tenants should be the starting point for finding solutions that benefit all parties. At the end of the day, we are all human beings.
Table 2 – Building Occupancy Summary (*NRAU – New Urban Lease Regime)
The analysis of Table 2 indicates the potential for appreciation of the asset, considering the significant difference between "Current Monthly Rent" and Potential Monthly Rent. We must not forget that the value of a real estate asset also depends proportionally on its ability to generate income.
Legalizations and Licensing
Checking the licensing history of the property and comparing it with the existing architecture is essential to mitigate risks associated with legalization needs. Discrepancies between the areas registered in the Urban Building Booklet and the existing areas are common, even in cases where the original plans match the existing building. When in doubt, it is always advisable to conduct an architectural and topographical survey of the building.
In this specific case, another recurring situation is addressed. One of the apartments was originally licensed as "Casa de Porteira" (porter's lodge), considered a common area. This is a normal situation that can be resolved through a change of use request.
Another common scenario in these types of assets is the possibility of balconies being transformed into enclosed spaces (marquises). The restoration to the original state may be required by the Municipal Council. However, legalization may also be considered.
Lastly, it is recommended to assess the potential for expanding the property. This situation does not apply to the case under study.
Intervention Diagnosis and Associated Cost Estimation
The assessment of the conservation status is crucial for decision-making, especially considering the significant property age.
The need for structural intervention is a critical factor. The building infrastructure (plumbing, electricity, gas supply system, etc.) may require a complete overhaul.
After identifying the intervention needs, it is necessary to estimate the associated costs. I believe that the cost estimate should encompass not only the improvement of habitability and comfort conditions but also the extension of the property's lifespan. Sometimes, a mere cosmetic upgrade may not suffice.
In the case under study, let's assume it is a building with a reinforced concrete structure, where no structural reinforcement or intervention is needed.
Brief Overview of the Planned Works:
Renovation of Common Areas and Circulation Spaces: Infrastructure review (plumbing, electricity, gas supply), regularization and painting of facades, renewal of staircase coverings and respective paintings, roof inspection, and elevator replacement.
Apartment Renovation: Bathroom renovation, kitchen renewal, window frame replacement, painting, renewal of coverings (where applicable), plumbing, electricity, and gas system review (where applicable), and other repairs.
Regarding the estimated cost of the works to be executed, it is assumed that vacant apartments require more substantial intervention, as specified in the previous table (Table 1).
Table 3 - Estimated Cost of Works (*NRAU – New Urban Lease Regime)
In Table 3, an estimate of renovation costs per apartment, including improvements to common areas, is presented.
Conclusions
The value creation process in Real Estate Development Assets is always a dynamic discovery. Each case is unique. However, in cases similar to the one presented, I consider two fundamental factors for the value creation process:
Flexibility: What can be done to make the asset more "flexible" considering its occupancy characteristics?
Liquidity: What can be done to make the building more "liquid"?
After completing the Diagnostic Analysis, objectives are established, and scenarios are created to enhance the asset's value.
The establishment of Horizontal Property (PH) should be considered.
In cases where there are no changes to the existing licensing, the creation of the PH can be a straightforward process with a very low cost compared to the enhancement it allows.
Why?
Let's assume that the Market Value of the building, considering the conditions specified in tables 1, 2, and 3, amounts to approximately €3,300,000 (Three Million Three Hundred Thousand Euros), or €2,895/sqm. In theory, there are more clients willing to acquire autonomous fractions for €275,000 (€3,300,000/12 = €275,000) each than clients willing to acquire the entire building for €3,300,000.
If there is a higher demand volume and the supply is finite, the tendency will be to increase the selling price.
Furthermore, the possibility of selling the apartments separately allows increasing the unit sales value of the units without existing "burdens".
This option will also enable the heir(s) to create the necessary liquidity for the renovation and enhancement of the asset by selling some units without the need for additional sources of financing.
On the other hand, there is the issue of divisibility. In cases with more than one heir, some may keep units of the building, while others may sell.
This increases flexibility and the number of options in the division of the undivided inheritance.
Establish goals to maximize the building's income
The case under study indicates the existence of six existing lease agreements.
Lifetime Contracts – There are three lifetime contracts where opposition to renewal will not be possible. Various negotiation options can be considered. In this specific case, I will opt for a simpler negotiating assumption.
Give tenants or their families the opportunity to purchase the property. The burden associated with a lifetime contract is a factor that devalues the property in the market. For the tenant and their family, there is no burden. This solution can benefit both parties (Landlords and Tenants).
If we are unsuccessful in this procedure, we can consider updating the rents if not already done.
Specifically, let's assume the sale of the three apartments with lifetime contracts, establishing the unit sale value (price per square meter) according to the Market Value obtained in the assessment for the sale of the entire property in total ownership (€2,895/sqm).
Table 4 - Established Selling Values for Lifetime Contracts
The table 4 indicates the possibility of raising €750,000. This amount comfortably allows for the execution of the planned works, freeing up some liquidity for other investments or addressing any other needs.
NRAU Contracts (New Urban Lease Regime) – The goal will be to increase rents to levels set by the affordable rent program, offering tenants the opportunity to carry out improvement and conservation works to enhance living conditions and comfort.
Vacant Apartments – Execute conservation and renovation works and place the apartments on the rental market. The objective will be to maximize rents according to market levels.
Next, a summary table is presented outlining the established objectives for the units with contracts under the NRAU and also for the vacant ones.
Table 5 - Summary Current Rent vs Potential Rent Map
Through the analysis of Table 5, we can observe the possibility of a significant increase in the building's income.
The initial occupancy scenario of the building provided an annual income of €35,400, assuming the 12 fractions of independent use and total ownership regime. The establishment of horizontal ownership will allow the fractional sale of apartments, ensuring liquidity for improvement works. If we assume that fractions with lifetime contracts will be sold, there is no need to resort to other sources of financing.
In total, we have a global investment of around €440,920 that will enhance the property's income by about €10,075/month, or €120,900/year. If we calculate the return on investment, the result is very interesting:
Annual Return Rate = €120,900 / €440,920 = 27%
I believe there are other investment opportunities with attractive returns. However, a 27% return is extraordinary.
3. Decision Making
After analyzing the risks and establishing an action plan to mitigate them, the decision-making process follows.
To Sell or Create Value?
It's not an easy answer. It depends on various circumstances that are often uncontrollable. However, if the client(s) are not aware of the options and scenarios, the "destruction of value" can become a reality.
We all know that the customer is always right, indeed. However, as Henry Ford said, "If I had asked people what they wanted, they would have said faster horses."
What the customer "asks" for is not necessarily what they want.
Real estate consulting should always prioritize the best outcome for clients, even if the most suitable solution is not the most profitable in terms of service provided.
See you soon,
