By Chad Braun, Co-Founder & Managing Partner – Fifth Corner, LLC.
The Implied Dirt Value of a property provides a measure of downside protection and contributes to value creation optionality. When the improvements are a smaller component of the total acquisition price, the dirt value provides a measure of protection and optionality as over time uses may change. In the future, the land may be better served with a vertical development like multi-family, office, hospitality, or a mixed-use. The Implied Dirt Value becomes more and more significant depending on how much of the value is in the land versus in the improvements. With other multi-story uses (e.g., office, multi-family and hospitality), land is a much smaller percentage of the overall project and does not create the same downside protection or option for future value through redevelopment.
In the case of community and neighborhood retail real estate, such as shopping centers, the Implied Dirt Value can be a significant % of total value. The primary reason is the property is typically single-story real estate with surface parking. There just isn’t as much in the way of improvements compared to office, hospitality, or a multi-family project. For exceptionally located properties in the strongest, most affluent, densest markets, the dirt value can be 60% to 70% of the purchase price – providing great downside protection and optionality for future value.
We will illustrate this principle with some hypothetical illustrations.
Let’s take a shopping center that is located in one of the fastest growing affluent submarkets within the Texas Triangle. Let’s also assume that the Average HHI within a 1-mile radius is over $100k, with a population density over 100k and daytime employment population over 150k within a 3-mile radius. The center, and its tenant mix, caters to both the surrounding neighborhood and the local employment base.
To calculate the Implied Dirt Value we will look at the property land size by square feet, local comps and the property basis or cost. In this hypothetical example, the property is located on roughly 400k square feet of land. That equates to about 9 acres. The land value comps indicate the land value is about $65/sf for an Implied Dirt Value of $26MM. Assuming a basis in the property at $40MM and 65% of the implied total property value is in the dirt. Thus, only 35% of the value is accounted for in the improvements, which provides significant downside protection to the investment. In addition to the optionality created by the Implied Dirt Value, the property would also generate a very good income and current yield. The combination of income producing properties with significant Implied Dirt Value is what mitigates the risk and protects the downside while preserving the upside opportunities.
In the current lending environment, the high dirt value and strong performance fundamentals are also reasons banks favor making loans to these types of neighborhood centers. They are viewed as good stores of value and the bank views the downside protection as a strong indication of risk mitigation when underwriting the loan. This high implied dirt value allows for more favorable debt terms than other properties that might not have the same risk profile.
Covered Land Play
In the event the dirt value exceeds the value of the improvements this typically is viewed as a Covered Land Play. In this situation, the retail property generates income, but the market is signaling there is a recognized higher and better use that the property should or will be positioned for. In the case of an urban shopping center, the better use is usually redevelopment for a denser use such as multi-family, office, hospitality, and/or some other vertical mixed use.
Let’s use another hypothetical example for a property located within the Texas Triangle. This time we will assume similar demographics as mentioned earlier, but here the submarket is already experiencing vertical development with office and multi-family. The shopping center has a rectangular footprint of 90k square feet, which is a nice 2 acre size for vertical urban development.
In this example, land values are approximately $160 per square foot, resulting in an Implied Dirt Value of $14.4MM. Assuming a basis of $14MM in the property, the Implied Dirt Value is 103% of the property value, indicating there is more value in the dirt than the cash flowing leases in place. This is an example of the market telegraphing that the highest and best use is not a shopping center, but likely a denser use such as multi-family, hospitality, or office. In the interim, the property generates a nice cash yield, which is what creates the covered land play.
Competitive Moat & Summary
Our 5-D Investment framework coupled with the lack of supply, replacement costs, and cost of new construction create a competitive moat for Irreplaceable CornerTM properties. The Irreplaceable CornerTM has the affluence, density, daytime and nighttime demand drivers and is important to the community where it is located.
More and more is being written about the lack of new retail supply, and construction costs are a contributing factor. Replacement cost is roughly $200/sf for the retail shell and then another $100/sf in tenant improvements and leasing cost for a total of $300/sf replacement cost in Texas. This coupled with growing land value is where the competitive moat comes in. You just can’t build new retail in these markets at current rental rates. So, the well-located properties are highly desirable to tenants. They understand location matters and that it impacts their level of potential sales.
Many people will simply look for ‘cheap dirt’, but it doesn’t matter how cheap the dirt/value is if you can’t generate growing cash flow and realize any future value creation. When you can acquire very well-located properties with over half the value in the dirt, you have the making of an Irreplaceable CornerTM. The rest of the value will depend on a very deep understanding of the local market, trends in place, and an exceptional team to execute the strategy and manage the property.
The founders of Fifth Corner pioneered the concept of investing in Irreplaceable CornersTM. They even trademarked it! If you have any questions or would like to learn more about investing in these types of properties, please reach out to David Hicks (david@fifthcorner.com) or Chad Braun (chad@fifthcorner.com).
About the Author:
Chad Braun started his career with Kenneth Leventhal & Co in their real estate advisory practice and has spent the past 25 years exclusively working in the commercial real estate business. He helped grow AmREIT (NYSE:AMRE) from $50 million to over $1 billion in assets when it sold to EDENS in February 2015. As CFO and COO, he was responsible for over 60 employees in multiple offices, all aspects of debt and equity capital formation including leading the Company’s IPO on the New York Stock Exchange, accounting and reporting, asset and portfolio management, investor and institutional relations and human resources. Chad is currently the Managing Partner and Co-Founder of Fifth Corner, a private equity real estate firm focused on creating value on Irreplaceable CornerTM properties throughout the major markets of Texas and the Southeast United States.
