The conversion line on page 14 is carrying a third of the downside case

Question

Reading a deck on a 1980s eight story, 140,000 sf, 54 percent leased, and the downside case doesn't end in a loss because of a line that says "residential conversion, $185/sf all in, exit at $290/sf." That single line is holding up about a third of the protected value in their bear scenario.

I came at real estate from the build side and that number looks like a wish. Conversion on an eighties floor plate means core-to-window depth that often can't produce a legal bedroom without carving a light well, plumbing risers that don't exist where you need them, a curtain wall that may not open, and a change of use that has to clear zoning and code in whatever jurisdiction the building sits in. That last item swings hard between one city and the next, and I have never once seen it priced in a deck. I've seen structural work turn a per foot budget into a different budget entirely.

The counterargument is that conversions are actually happening at volume. Obsolete buildings are being refurbished into apartments all over the country, some cities are actively encouraging it, and if you buy the office at $60/sf you have room for a lot of surprises before you're underwater.

So where does conversion belong in an underwriting? As a real value line with a number attached, or as a note in the margin that says "an exit exists, unpriced"? I lean one way for reasons I trust and one way for reasons I don't, and I want to hear people push on it.

kevin_lombard · Answer

If the sponsor never intends to do the conversion themselves, then that $290/sf exit assumes some other buyer shows up who does want to do it, right? So the line isn't really a construction budget at all. It's a guess at what a conversion developer would pay for the shell in a bad market, which sounds like a much softer number than a per foot cost that at least someone could bid.

girder, does the deck say who's supposed to be doing the work?

paulgrant17 · Answer

juniper's question is the one I'd want answered first. My whole reading right now is tenant screening on a single rental, so I'm out of my depth on the construction, but I do notice the deck put the friendly number in the downside case. That's where the number does the most work and gets the least scrutiny, and it's a lot easier to write $290/sf than to write "we don't know what this shell is worth if leasing fails."

The conversion line on page 14 is carrying a third of the downside case

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