So I've been playing with some spreadsheets in my spare time over the last week. The basic question I'm trying to answer is, "What could you afford to pay for the building in order to renovate it as office space and make an acceptable profit?" The owners have suggested this is one option they are looking at, so it is what I've focused on since it is the most straight-forward option.
The building is for sale at an asking price of $11 million - it was bought in 2004 for about $5 million. For a starting place, consider that the already renovated and income producing Imperial Hotel nearby is valued by Fulton County presently at $5 million, and the Medical Arts Building is valued by the County at $3 million. So we have quite a discrepancy already.
You can see the details after the jump, but I've used a residual analysis to come up with an idea for the value of the building. Basically, you say, "It costs me X to renovate, I can sell it for Y, and I need to make Z profit. So I can afford to pay up to the amount that my profit drops to Z." (Feel free to download the spreadsheet and follow along. See below for important notes.)
The point of the analysis is to make this basic point - many, many property owners in Atlanta have completely unrealistic conceptions about what their property is worth. This fact makes is very, very difficult for areas like Downtown to have the type of turn-around we all want to see. Here, you have owners asking $11 million for a building, and the absolute maximum amount possibly justified that someone could pay for the building is $4 million less than that.
- The main findings are that a reasonable price that could be paid in order to redevelop the building for office use would be about $2 million. A reasonable top-line, in my estimate, would be about $3 million with a number of favorable assumptions.
- Under absolutely optimum (read: completely insane and impossible) conditions, you could justify paying up to $7 million dollars for building, but this assumes minimal construction costs, maximum rent levels, very low cap rates, minimal T.I. allowances, adding the building to the National Register to qualify for maximum historic tax credits... a perfect storm of events no one in their right mind would bet on, which is what you'd be doing if you paid $7 million for this building.
- It is much easier to see a scenario where construction costs are at their highest, rent levels stay very low, tenants continue to demand high T.I. allowances, it takes forever to lease things up, and cap rates move up. In that case, you wouldn't pay anything at all for the building because you'd never actually develop it. In case you were interested, this is basically where the market is now, although I think construction costs might have come down a bit from a few years ago. It isn't that the building is worth nothing, it is just that you can't do anything with it given present conditions.
Now, it is possible that you can do some other analyses with a different use than commercial office space - you could run a boutique hotel scenario, or convert it to condos, etc. Perhaps a different scenario would be more profitable and push the value of the building higher, but I don't see any reasonable way you could justify paying more than about $4 million for that building, and even then I'd suggest you overpaid. It is probably worth analyzing the value of the property if you just tore the building down, as sad as that would be. [Ed. update: Some back-of-the-envelope calculations suggests that tearing it down would be more profitable. Assuming it costs around $900,000 to demolish it and the associated parking decks, you'd only have to get about $100/sf to exceed the $3 million mark.]
Realistically, the owners of this building overpaid when they bought it six years ago. They haven't done anything with it since then. Somehow they have held on to the property and not given it up in foreclosure, despite the fact that it doesn't produce any income [correction: it does produce some income in parking and with these billboards]. If they can keep holding on, I would be very surprised if anything happened to the Medical Arts Building any time soon.
If you want to see this building redeveloped any time soon, you are hoping it goes into foreclosure and a bank sells it for a realistic value to get it off their books.
If that wasn't a long enough post, you can see the details of my analysis after the jump. Be warned: full-on geek mode follows. I'm not sure how much will make sense if you don't know some level of real estate finance.
I was going to put my spreadsheet on Google Docs, but unfortunately it does not circular reference and iterations. So feel free to download the file here and play with it yourself. Make sure that you are allowing circular references by limiting the number of iterations to about 100. Try Preferences > Calculation > Limit iterations.
Hopefully I've built the spreadsheet to be robust enough that you can tweak the timing or inputs a bit and it won't break. If you do play with the timing, note that I've used a quarterly cash flow. Feel free to email me if doesn't seem to work, although I'd suggest you stay within the range of inputs I've used in the sensitivity analyses. I haven't tested it much beyond those parameters, and I've locked the non-input cells. It isn't password protected, however, so feel free to mess with it all you want.
Obviously, input values are rather important with this sort of analysis. Some assorted notes on my inputs and on the model in general:
- I talked to a construction engineer at a larger company locally about some very generic cost estimates for a building of that size. He suggests that hard costs for this sort of building would run between $60 and $80 per sf.
- I had a broker friend pull some current asking rents for comparable buildings, like the Candler Building, Hurt Plaza, and the Biltmore, and it looks like gross annual rent levels run from $15 up to $30 per sf. I also see some asking rents at Allen Plaza for $30 per sf, but also at the Candler Building. My starting assumption is $27, given the building's prominence, historic character, proximity to MARTA, and that you are spending enough on the renovation to be fairly competitive with places like the Biltmore and the Candler.
- The building is eligible for a local property tax freeze, and qualifies for a partial Historic Rehabilitation Tax Credit since it is old, but not on the national register. I've taken these into account, and also run some sensitivity analysis to see how important they are to the building's value (short answer: a lot). If I were aiming to rehabilitate the building using historic tax credits, I'd seriously consider trying to get it on the national register.
- The historic tax credit is really an after-tax cash flow item, but I'm looking at before tax returns and so I've basically just wedged it into the cash flows. From that perspective it is probably undervaluing the tax credit, although I'm honestly not really capturing the full cost of the tax credit in terms of consultants and extra construction costs, either.
- Additionally, the historic tax credit requires that you hold the building for 5 years, so I've included that as well. This model isn't quite robust enough to factor out a non-historic tax credit scenario, however. My instinct is that it might be slightly more profitable to do the deal without a tax credit and sell it early, but that it wouldn't dramatically alter the underlying conclusion, namely the discrepancy between the owners asking price and a realistic value of the property.
- I've used some other assumptions that are certainly unrealistic in today's market, such as assuming the building could lease up in about half a year. The arguments there are a) the scenario takes place after the market recovers; b) you don't start construction until you've pre-leased some portion of the building. I'm also showing a traditional 20% equity requirement for the development. In today's market, that isn't realistic, either. In this model, I'm valuing the building off its unlevered cash flow, however, so it doesn't affect the valuation of the property - just the equity returns. Using a more realistic leverage ratio would bring the equity return below traditionally acceptable levels, but I see that as something that all projects are dealing with and not something specific to this building.
- I haven't tried to break out all the soft cost items in much detail(architectural fees, leasing commissions, insurance, legal fees, marketing costs, etc.), but there is a small break-out of these costs on a different sheet if you are interested.
- You can see some sensitivity analysis at the top right of the spreadsheet. Depending on how you tweak your inputs, you can arrive at a value that ranges from literally nothing to about $4.7 million. I've tried to use middle-of-the-road inputs as the base line, so if you want to get to the $7 million I mentioned above you'd need to tweak ALL the inputs in the model, not just the one or two that the sensitivity scenarios take into account.
UPDATE 2/22/2010: I tweaked the spreadsheet a bit, adding in a CapEx reserve and parking income. They essentially cancel each other out and don't change my valuation assumption.