When Value-Add Means Buying 460,000 SF Of Vacancy

David Rubenstein of Rubenstein Partners discusses finding value in U.S. office markets, taking on a vacant 460,000-square-foot complex and a fully occupied office in a “messy” Boston neighborhood.

In today’s highly competitive and capital-rich commercial real estate markets, mean reversion theory should be dominating every investor’s mind as he or she weighs the true risk-adjusted returns of deals. After all, what goes up must eventually come down.

For David Rubenstein, founder and senior managing partner of the office investment firm Rubenstein Partners, it means that deep value must be found in every deal, not least given the wave of capital targeting U.S. real estate and its impact on valuations.

“You either get caught up in market momentum, which is what most people do when rents are at their highest and people believe things are going to grow…because great things have already happened,” says Rubenstein, “or you believe in mean reversion, which is basically all that goes up eventually comes back down to reality. We are very mean reversion-orientated.”

That’s not to say Rubenstein Partners believes a bubble is about to burst. Indeed, Rubenstein argues that while U.S. real estate markets—particularly those on the East Coast, where his firm focuses its investments—are increasingly competitive, “we are also seeing more opportunities.” He stresses, though, that it’s all about finding deep value-add.

The firm’s acquisition of the former Sony Ericsson headquarters in North Carolina’s Research Triangle Park is a case in point. Rubenstein took on the 460,000-square-foot office and laboratory space after it had been vacant for three years, acquiring it in December 2013 for $26M.

Vacancy in the park was running at 23 percent, and Rubenstein openly admits he was repeatedly told the property was a “white elephant” and that the deal was “one of the stupidest acquisitions to ever happen,” adding that “we heard that time and time again.” Rubenstein sold the asset in February 2015 for $127M after Lenovo Enterprises leased the entire space following its own acquisition of IBM’s low-end server business.

“The headline vacancy risk was the biggest fear people had when they looked at this deal,” says Rubenstein. “It equated to 2.6M square foot of vacant space. But when you actually dug into the vacancy and you looked at the functional available space in the park and space that was obsolete, it was a different story.” The firm calculated obsolete space in the park—comprising properties that would cost more to renovate to 2015 standards than returns could warrant—at roughly 1.5M square feet of space. Also taking into account the volume of fully-owner occupied space, those calculations brought the vacancy rate down to around 7 percent.

That didn’t mean there weren’t risks. Rubenstein Partners underwrote the deal with a multi-tenant, lease-up strategy and assumed “it would take a long time to lease the entire building.”

However, one month after Rubenstein bought the property, Lenovo announced its own $2.3B deal for IBM’s Research Triangle Park–based server business and, as a result, needed more than 400,000 square feet of space to accommodate the more than 1,500 employees coming from IBM. It took Rubenstein and Lenovo five weeks from the issuance of a request for proposal – with 11 days of actual lease negotiations – to agree on a lease deal that included plans to build an extra 30,000 square feet of space.

“We are trying to get ahead of the curve when buying,” says Rubenstein. “That’s one of the only ways to get a buying advantage. You need to see something different in 450,000 square feet of space that has a headline vacancy risk of 23 percent. We are trying to buy where the market thinks one thing is going to happen and we think that in three to four years things will be very different.”

That’s certainly the strategy behind the firm’s latest deal, the $75M acquisition of 1000 Washington Street in Boston. The fully occupied 11-story office property that Rubenstein acquired in partnership with existing minority owner Nordblom Co. is in the developing fringe of the South End area of Boston, which Rubenstein believes is undergoing a transformation.

“Five years ago, this was a completely different area comprised mostly of warehouses,” Rubenstein says. “Today there is construction all around us—we’ve already seen a 500-unit multifamily property come to market, a Whole Foods is opening across from our property, and another 600-unit multifamily property is going to be open very shortly. We have a lease that continues through this neighborhood transformation period of time allowing us, thereafter, to release into a completely different area with a new renewal-rate level.

“You don’t need to focus on specific markets—we’re market agnostic—but you do need to focus on where the opportunities are and the strength of the opportunities that arise,” says Rubenstein, adding that everyone needs to underwrite carefully, with an ever-present eye on real estate cycles. “Underwrite accordingly; underwrite your rental-growth assumptions and the amount of time it will take to lease up in the context of normality and long-term trended equilibrium. Don’t get caught up in market momentum.”