For a small check, is a conversion fund with ten buildings safer than one building you can actually go look at?

Question

The two doors I keep getting shown for conversions are pretty different, and I'm not sure conversions are somewhere I belong at all with a small portfolio of ordinary rentals.

Door one is a fund. A platform raising, say, $200m to buy obsolete office and convert, eight to twelve buildings, blind or mostly blind at the time you commit. The case for it is that conversions fail building by building. Floor plate, window line, riser capacity, and each one is its own coin flip. A fund lets one bad building be a bad building instead of your whole outcome, and the sponsor doing it ten times has seen the failure modes.

Door two is a single asset. One building, named, you can stand in the lobby, you can read the actual feasibility report and the actual budget for the actual structure. The case for it is that a conversion is a construction project and the specific facts are the whole deal. In a blind fund you're buying a process you can't inspect, and you're paying fees on committed capital while the sponsor goes hunting. If the strategy is that most buildings don't pencil, a fund still has to find ten that do, and the pressure to deploy is real.

There's an honest third answer too, which is that a small check has no business in either one and should sit in something simpler until it isn't small.

I genuinely don't know. The diversification argument sounds right when I say it out loud and the inspect-it-yourself argument sounds right when I write it down.

megan_doyle15 · Answer

Brand new here so I might be missing something obvious, but if most office buildings don't convert well, doesn't a fund buying ten of them just guarantee you own some of the bad ones?

tylerbrooks9 · Answer

@rigging that's the counterargument in one line and I don't think it's naive. A fund averages outcomes. Averaging is good when the individual outcomes are random and bad when the individual outcomes are selectable. Whether conversion feasibility is selectable is the actual question in this thread.

I voted for the third option. My version of boring says if I can't judge the building I shouldn't be paid for judging the building, and in a fund what I'm really underwriting is one team's judgment for six years, which is harder to check than a floor plate.

carlos_nunez · Answer

Feasibility is absolutely selectable and I'd say that's the whole argument for the fund. The teams doing this at volume look at forty buildings and buy three. I look at one building and I want it to work, because I found it and I've already spent money on it. My discipline on a single asset is worse than a stranger's discipline across a pipeline, and I say that as someone with two deals in progress right now that I'm too attached to.

@thicket, the fund fee drag is real though. Fees on committed capital during a two year acquisition period is a genuine cost and it comes straight out of your number.

mitchell_ray4 · Answer

Trades side view. The thing that kills these is what's inside the walls, and you can't see that from the lobby. So the "go stand in the building" advantage is smaller than it sounds unless you're paying for probes, cores, and a full mechanical assessment. Which the fund is doing on every building and you probably are not on your one.

The flip side is the fund did all that and you never get to read it.

tashaford30 · Answer

The single asset lets you read the report. Does anyone actually get the full report, or is it always a summary memo? Because if you get a memo either way, door two loses most of its advantage.

tonyv88 · Answer

@quill in my experience you get the full report if you ask early and you're a large enough check, and a memo if you're small or late. So for a small check the difference between door one and door two might collapse to nothing on the information side.

Management angle nobody's raised: a converted office building is an operating asset with weird bones. Odd unit layouts, interior units with borrowed light, one elevator bank sized for 9am office traffic. Lease-up on those runs differently than a new build and the pro forma rent per foot often assumes it doesn't. A fund with ten buildings has ten of those problems and a team that has seen them. That pushes me toward the fund.

ryanmck27 · Answer

Voted fund. My reasoning is unglamorous, I'd rather diligence one team once than one building repeatedly.

diane_kowalski · Answer

I'd separate two things that keep getting mixed here. Diversification of building risk and diversification of sponsor risk are different, and a fund only gives you the first. Ten buildings, one team, one set of judgment errors, one guaranty behind everything. If the team's cost assumptions are systematically light, all ten buildings are light in the same direction and the diversification does nothing for you.

Ten single-asset deals with ten different sponsors would give you both, and almost nobody has the check size or the time to do that. Which is maybe why @verity's third option keeps looking reasonable.

aaron_fitz10 · Answer

@arbor's point is the one that moved me. Correlated errors across a portfolio is exactly what conversions would produce, because everyone is using the same cost data and the same optimism about permit timelines.

Still voted fund though, because the alternative for me isn't ten sponsors, it's one building I don't understand.

jordan_ellis2 · Answer

I've been reading for six months and have closed nothing, so take my vote as a vote and not as a view. I went with the third option. What decided it was @thicket's own sentence about pressure to deploy. A fund that raised $200m has to spend it, and a strategy that depends on saying no to most buildings sits badly with a fund that has to say yes to enough of them. I'd rather watch a couple of these funds report actual conversion costs against their original budgets for another year or two before I have an opinion worth acting on.

For a small check, is a conversion fund with ten buildings safer than one building you can actually go look at?

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