When it comes to commercial real estate, there is rarely a dull moment. That’s why some may find themselves perplexed by a term like “transitional real estate.” Markets and properties are always changing, at least in the long run. While some find the term vague and unhelpful, unpacking and defining it can prove valuable to an aspiring investor. At the end of the day, it’s about profit potential. Like energy loaded into a spring, transitional markets, properties and lands are poised for change. It’s up to the savvy investor to understand when market dynamics align with a great property at the right price to create a diamond in the rough.
In the spectrum between dubious and safe investments, you can think of “transitional” real estate somewhere in between. Rather than investing for slow and steady cash flow, most investments in transitional real estate are made for the purpose of buying low, adding value and selling high.
Before an investor sets his sights on an individual property, it’s important to understand the greater market dynamics at play. If we think about the real estate cycle as the tides of the ocean, then a market “in transition” is somewhere near slack tide, flowing in favor from buyer to seller or vice-versa. In a buyer’s market, supply exceeds demand. And in a seller’s market, demand exceeds supply. A market in transition achieves a relative and brief equilibrium between the two. Many people involved in real estate know which way the tide will turn, and will act in their best interest. In this way, it’s the anticipation of future supply or demand that dictates the market. That’s why it’s important to understand transitional market dynamics, no matter which side of the equation you’re on.
To elaborate, there are actually two types of transitional markets. If we think about the real estate cycle as a tide, then you know there’s a difference between high tide and low tide. At both ends, the water becomes briefly still, but there’s a difference in knowing the tide is about to come in — you can venture into shallower waters, or is about to go out — it’s time to get out of the marsh before you’re stranded. In the real estate cycle, these two phases are called “peak” phase and “bottom” phase. At the peak phase, your market has just undergone an expansion but it’s leveled off reaching that slack tide equilibrium. You anticipate a contraction coming. And the bottom phase happens after a recession has run its course. Like rock bottom, you know it can’t get any worse and that a recovery is coming.
However, if markets were as predictable as tides, then there would be no such thing as risk, values would be hard numbers, and there would be no profits to be made. With the right advisor or years of experience, it’s up to the investor to make the best possible educated guess on the market and to distinguish between a good deal vs bad deal in commercial real estate. Finally, people often think of “the market” as a behemoth that governs everything. Quite the contrary, the market can differ greatly by geography and property type. For example, 2020 saw the urban hospitality market nosedive while single tenant net leases became coveted assets.
Economics is not a hard science, so it’s never clear exactly when you’ve truly hit peak or bottom. However, analysts keep tabs on several metrics to get an educated guess. When it comes to commercial real estate, Gunnar Wilmot, Senior Financing Broker at Lev, a digital-first brokerage, said, “The most important metrics are cap rate and price per square foot.” Wilmot, who facilitates hundreds of triple net lease deals with steady tenants such as Walgreens, has seen cap rates rise a full hundred basis points for such properties. To review, cap rate is calculated as net operating income (NOI) divided by a property’s current market value. To read the market, a potential investor could look at properties of a similar type in the neighborhood of interest and compare their cap rates over the past three months to look for trends.
The savviest of investors will look beyond the properties themselves. National trends in interest rates, projected changes in population and income in a given neighborhood, and even city beautification projects could all factor into an investor’s confidence.
To receive the highest profits, you’ll need to keep an eye on comparative prices and associated costs of the properties you’re interested in.
When properties of a certain type are at their peak, they are a well-known and coveted asset. As a result, there will be far more buyers willing to pay top dollar for any property that hits the market. Wilmot recommended buyers have their financing, equity and due diligence lined up or risk losing out to all-cash buyers. On the other hand, if an investor can predict the market will transition to favor buyers soon, they may decide to stay informed and wait it out. Suppose, for example, there was a boom in development due to projected demand, but an unexpected economic downturn just hit, leaving inventory high and dry. The patient investor can now revisit a property of interest to see if he can’t negotiate a better deal.
When a depressed market suddenly gets an air of optimism, the poised investor can certainly stand to turn a healthy profit. Perhaps she has ears to the ground on a future rezoning and can act with information unknown to a seller.
On the other side of the equation, a seller’s fate during a downturn has everything to do with how nimble their exit strategy is. Did they build contingencies into their business plan for occasions like this? Perhaps they can see the situation cooling off before the news hits the mainstream. In this case, their ability to sell quickly will save them from harsh losses, perhaps even protect their return on investment.
If a seller can see an upturn around the corner, they may want to hold on just a while longer to their current financing or even consider refinancing under more optimistic terms. They should try their best to find optimistic buyers who see the potential in their property and better times ahead. Perhaps they have a distressed property on a desirable block in an up-and-coming neighborhood. The city has just begun a revitalization and although it needs renovations, the building’s foundations are solid. The owner has run out of funds to renovate but knows that the ideal buyer will see the solid brick behind a shoddy paint job.
Now that we have discussed market dynamics, we come to individual properties. While the term “transitional” may appear all-encompassing, a property can be called “transitional” regardless of what the market might be doing. Alliance Bernstein, a global asset management firm, defines transitional properties as fundamentally stable but in need of value-added improvements.
Stabilized properties are not likely to improve upon their existing net operating income. Perhaps they’re fully renovated and above 90% occupancy in a coveted neighborhood. Though their current owners may enjoy a healthy cash flow, they are not necessarily the right buy for an investor looking to reap a large return on investment. That’s where transitional properties come into play. If bought at the right price, at the right time, with enough capital left over for improvements, then they can become a true diamond in the rough.
Boston Appraisal Services highlights four helpful criteria for assessing improvements to a property:
If the improvements in your business plan meet these criteria, then you’ll have the “Midas touch.”
Another term you’ll hear thrown around a lot is “transitional land.” You may ask, “Isn’t all land transitional?” After all, we live on an ever-changing planet, subject to disasters, seasonal shifts and climate change. However, as an industry term, transitional land has more to do with land that investors expect to be rezoned in the future, often after some transformation. Perhaps this land is in the “path of progress” on the outskirts of a growing suburb. Perhaps it’s shrubland without access to utilities. It will need substantial transformation to be prepared for future construction.
In the succession of real estate, you can think of land prospectors as the first investors in a property. Even before construction begins, they invest in transforming the land into something more profitable. Often using predevelopment loans, these investors may clear the land, channel streams together, and connect the access to municipal utilities, all with a plan to sell it to someone with more interest or experience in construction, which requires its own kind of financing and its own risk profile. A fantastic example of transitional land is the story of Disney World. Before it became the make-believe mecca it is today, Walt Disney had to find cheap land in a growing population center with great access to highways. Flying over southern Florida in 1963, he found his mark — the swamps near Orlando. To get perspective on how the area must have looked, visitors can visit The Green Swamp Wilderness a mere 20 miles west as the crow flies.
But where others saw swampland, Disney saw the possibility of “Disney Land East” where Interstate 4 and the Florida Turnpike were projected to meet. Forming a series of shell companies, he was able to gobble up land at prices as low as $100 an acre. He did his best to keep this “Project X” under wraps, but people did eventually catch on. Nevertheless, the average cost came out to $200 per acre.
As you can see, transitional real estate does not fit neatly into one box. But unpacking the term gets the aspiring investor thinking about the role of transformation in profit potential. Ultimately anything transitional involves risk, and the risk profile for a worn-out historic building in up-and-coming Bushwick, Brooklyn is going to differ from the barren shrubland outside of a fast-growing Las Vegas suburb. That’s where the proper research, experience, and advisor comes into play.
