Reader Question: Monty, my partners and I have been in commercial real estate for 15 years. We own a variety of income producing properties. We have been toying with the idea of converting an old, vacant building. It is pretty, under the dust, but in rough shape. One of the issues holding us back is we are not certain to what use to convert the building. Also, we have never tackled something like this. What advice would you have for us? Michael V.
Monty’s Answer: This is an adaptive reuse project. Adaptive re-use in real estate means to recycle a building. It is changing the nature of how the building generates revenue or functions. It often requires a change in the underlying type of zoning.
Why does converting a building to a new use attract investors?
Investors and operators like yourselves generally have several motives for jumping in. The primary motive is profit and gain. Often, the basic idea of recycling, preservation or history is additional motivation.
Another driver may be an opportunity for your creative side to emerge and visualize the project as a learning adventure or adding another arrow to the business knowledge quiver. Regardless of the driver, determining profitably is the single most important factor.
3 things investors should look for in converting a building to a new use
- Where to look for prospective projects: You mentioned “vacant for years,” that is one of the signals that it may be a candidate. Here are some other signals that property may be ripe for adaptive reuse; doesn’t “fit” in its location, bank owned, for sale for extended periods of time, appears distressed, or prospects are afraid of it (such as brownfield contamination sites).
- What to look for in the building: Look past the leaking ceilings and the bats. You are looking for a solid structure, or a solid portion within a structure. It should also have ample property to expand or add parking, a new vision, located in a forward-thinking municipality looking for new tax base or willing to contribute capital, a good chance for rezoning, easy to gut and, if multi-storied, adequate square footage on each floor.
- Better returns: Will it survive the napkin profit and loss test? An early challenge is determining what to tear down and what to keep. There is more risk here and returns must be higher. First demolishing, then re-building offers much greater opportunity to miscalculate, or discover some unknown obstacle during demolition before you ever encounter controlling the new construction costs. If you get it right (you only get one chance) there is profit, valuable experience, professional recognition and respect.
5 things investors should consider in the path to follow next
Now that you may have located the right building, here is a list of major steps taken in seeking validation for an adaptive reuse project breaking ground now in Nashville, TN. It is named the INK building as it was a printing company being converted to high-tech office.
No. 1 — Identify the best candidate
There may be several candidates within a square mile or two. Compare them against the features necessary to succeed with a new vision. As an example, if office space is the choice, parking is important.
It is beneficial to have a choice. In Nashville, there were eight or nine candidates in the neighborhood and growing demand for office space.
No. 2 — Negotiate a planning option
You need time, and access and expertise to complete a stringent due diligence process so a cooperative seller is important. Creating design options, environmental testing, government approvals and finding financing can chew up six months quickly. Because you will have significant out of pocket costs and time invested, you want an understanding seller and a small refundable deposit.
No. 3 – Issue requests for proposals
Select vendors who have experience with this type of project. The time and the methodology to negotiate the conditions under which the working relationship with major partners is established is now. Develop interview questions and come to understand how the contestants do business as compared to how you want them to work. The INK building negotiated the fees for architectural design and a general contractor as a due diligence item before they decided to go ahead.
No. 4 — Interview commercial lenders
Develop a short list of potential lenders. Some lenders “don’t make adaptive reuse loans” and others do.
What you are looking for is a construction loan commitment to buy the building if it survives due diligence plus the demolition and reconstruction costs, less what they will require for your initial capital investment. The loan then converts or is recast to a permanent loan upon completion.
No. 5 — Once the team is selected, do the work
Inspections, concept plans, market verification of your vision, financial projections generated, value engineering on the developing working plans, consideration of construction methods and materials, letters of understanding or written meeting notes, submission of plans for zoning approvals, lender required appraisals and more.
Determine what it will cost to purchase, demolish, re-construct and that revenue and operating costs allow a satisfactory return within a predictable period, and you have a project. If it doesn’t work out with pencil and paper, it has no chance of working with brick and mortar.
“Richard Montgomery gives no nonsense real estate advice to readers most pressing questions. He is a real estate industry veteran who has championed industry reform for over a quarter century. You can ask him questions at DearMonty.com.