Every so often, a transaction crops up that challenges conventional wisdom. The consortium purchase, announced last Friday, of the vacant office floors of 685 Fifth Avenue in New York’s midtown Manhattan, falls into that category.
Certainly, the acquisition, led by Deutsche Finance Group and involving Turkish private equity real estate firm BLG Capital, German pension fund Bayerische Versorgungskammer and local developer Shvo, from retail property giant GGP, carries hallmarks unusual for an institutional outlay.
The JV invested $155 million of equity to buy more than 100,000 square feet of office space occupying the upper floors of the building with a view to converting it for other uses. They aim to raise approximately $100 million of debt to capitalize their plans. GGP retains the lower, retail floors in partnership with another private equity real estate firm, Thor Equities.
The resultant ownership structure is one of four risks that PERE believes the buying consortium will need to be alive to:
- Control risk
Joint venture investments can be complicated at the best of times. That complexity is compounded when the JV only owns one segment of the asset and the other is controlled by an entirely different partnership. The practice of splitting properties by use is not foreign to the US, but when there are multiple interests behind the split, their management takes extensive co-ordination.
The Deutsche-led JV intends to add five extra floors to the building, according to a permit filed with the New York City Department of Buildings.
The disruption caused by development could put a strain on the relationship between the two sets of landlords. Beyond that, the parties also will need to agree on ongoing maintenance costs associated with the property’s common areas and address unforeseen capital expenditures.
This is one reason institutions tend to refrain from strata-style ownerships.
- Partner risk
The six partners involved in the investment club are not strangers. Deutsche has worked with BLG Capital on Turkish investments, and BLG with Shvo on US deals. However, the relationship between Deutsche and Shvo is new. And the institutional investors— including German pension fund BVK and German insurer VKB – have only invested with Deutsche in the past. The more partners involved in a deal, the more difficult consensuses are to obtain.
Alignment may also become an issue, as the six different players have different business models and capital pools with different time horizons. Private real estate’s history books are peppered with examples of alignments on day one becoming misaligned over years. A prosperous market often compensates for such outcomes, but we are entering a downturn, even if it is not pronounced currently.
- Development and leasing risk
The vacancy presents the investors with a double-edged sword: it is attractive because of the opportunity to redevelop the space for a different use. No existing tenant negotiations are required either.
But because the partners will still need to find tenants, how and when the space is leased again is uncertain today. Then there are the risks in undertaking the redevelopment, such as cost overruns, project delays and regulatory hurdles.
- Financing risk
The consortium wants $100 million of credit to develop the building in early 2019. Today’s debt markets are not awash with lenders for speculative developments. The alternative lenders that are willing to take such bets want compensation for the development risk too, with the appropriate risk-return metrics. While traditional lenders would charge a blended rate of 200-375 basis points above LIBOR for construction loans, alternative lenders would charge 475-850 bps, according to one industry estimate. With such financing considerations, the onus on hitting the mark with the strategy is even greater.
Nevertheless, any lender evaluating the project will be comfortable with strong demand-supply dynamics in its locality, for multiple uses. Lodging occupancy in Midtown East rose to 79.3 percent in the first quarter of 2018 from 75.7 percent in the first quarter of 2017, and increased to 83.4 percent from 82 percent in Midtown East over the same period, according to PWC’s Manhattan Lodging Index report. The average vacancy rate for residential property in January was 2.44 percent in Midtown East and 1.94 percent in Midtown West, according to a report by real estate brokerage firm Corcoran Group.