Tuesday, March 29, 2016

Most Important Part of the Investment Thesis (hint: location, location, location)

Over the last two weeks I've been working around the clock on an investment memo for a deal that is going to be presented to our investment committee. The purpose of the investment memo is to cover every granular detail of the deal and present it in a way that is relatively accessible for the investment committee members. These memos can be over 100 pages long and typically contain the following info regarding the prospective deal:
  1. Investment Thesis - Why is this opportunity attractive? Why does the opportunity exist? How is my company adding value?
  2. Property Level Information - Overview of the property. Where it's located, what type of asset, square footage, etc...
  3. Submarket Information - Overview of the submarket the property is located in. What are the submarket stats (vacancy, rent growth over the last 10 years, projected rent growth, new construction underway, etc...)? Where is the property located within the submarket? Why is this submarket attractive for investment?
  4. Comparable Properties / Competitive Set - Detailed discussion regarding market rent comps / exit cap rate comps along with a look at competitive properties and how the subject property is positioned to compete. What are the market rents? Why would a tenant choose to rent space in the subject property versus other properties in the submarket? How much vacancy do the competing properties have? Etc...
  5. Risks & Mitigants - Discussion of what risks face the subject property and ways we are mitigating those risks.
  6. Project Underwriting - Discussion of underwriting assumptions and projected return metrics. Includes a comprehensive set of sensitivity tables for the most important variables (exit cap rate, general vacancy allowance, etc...).
  7. Capital Improvement Plan - A detailed look at what CapEx money is being spent and how it's being spent (300k for HVAC, 200k for roof repairs, etc...).
  8. Asset Management Plan - Discussion of how the property will be managed after acquisition. Who will the property management company be on the subject property? Who will handle the leasing? Any other operational issues that need to be addressed?
While putting this material together, I began thinking about what the most important aspect of the investment memo actually is. What does the investment committee care about the most? What's the secret sauce, if you will, to get a deal approved?

After seeing several deals get presented to our investment committee, I've seen some received positively and others not so much. After observing several of these, I've noticed a trend emerge: Properties that are well located within dynamic submarkets are almost a shoe-in to get approved. It's almost as if the rest of the memo is irrelevant as long as the submarket and location within the submarket are strong. For deals that aren't as well located the rest of the memo matters a lot more. Suddenly having good comps, a solid strategy, and a good grasp on the competitive set becomes much more important. If they're not airtight, the deal won't get approved. Clearly, the investment committee believes location is the by far the most important characteristic of a deal.

I think the primary reason location is the most important aspect of the memo to the investment committee is because it serves as a backstop. The investment committee is primarily concerned with the preservation of capital. If they put equity in a deal, their first priority is being able to get that initial investment back. A building with a superior location within a dynamic submarket is always going to have value, even at the bottom of a cycle. Even if the property is vacant there is still tremendous value in the dirt underneath the building.

I'd guess the second reason they are so focused on location is because well located deals are much more likely to surprise to the upside. If you buy a property in San Francisco, for example, any number of things can happen to increase the value of your property. Demand for your property type can keep increasing and drive rents higher. A tier 1 tenant, like Microsoft, could decide to lease your entire building one day. Zoning on the property could change and allow something with more density to be built which would increase the value of the land dramatically. A block away a huge company like Salesforce could build a new skyscraper and occupy several hundred thousand feet in it. All these things can happen in a city like San Francisco. They could also happen in cities like Austin, Denver, Seattle, New York, Boston, Miami, etc... You know where they aren't going to happen? Gilroy. In fact, if you look at commercial real estate prices in a town like Gilroy you'll notice that they haven't gone up much in the last 20 years. It's very possible if you buy property in a small town that it will be worth what you paid for it for a long time.

To summarize, my investment committee seemingly agrees with the age old saying that real estate is all about location. It certainly makes sense from their perspective. Their first goal is the preservation of capital. A well located property is very likely to, at a minimum, maintain its value. Their second goal is to generate a return on investment and they certainly seem to believe well located assets are far more likely to experience some sort of event that dramatically increases the value of the property, which will generate a high return on investment.

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