Business Models for LPs

Limited partners need to be very cognizant among business model risks pin up into their real estate portfolio. Case in point, if you have an asset that is specifically multi family asset, maybe high rise, short ceilings, mechanicals that are spread out throughout the building and it’s also in a dense area, it’s sometimes very expensive to re-purpose that if the multi tenant demand were to fail to exceed what your business expectations are.

Page Contents

• LPs Should Carefully Select Models
• Where to Find Different Models
• Why To Think About Choosing Models

LP’s Should Carefully Select Models

Limited partners need to be very cognizant among business model risks in their real estate portfolio. Case in point, if you have an asset that is specifically multi family asset, maybe high rise, short ceilings, mechanicals that are spread out throughout the building and also in a very dense area, it’s sometimes very expensive to re-purpose that if the multi tenant demand were to fail to exceed what your business expectations are.

To re-purpose it into a warehouse space or retail would be very difficult, probably cost prohibitive. And so the structure is your business model risk. The land is potentially the risky portion of it. So if you look at your structural value of the structure and the land and you look at the replacement value, it’s a functional replacement value. You’ll gauge the percentage of that which is your business performance risk versus your inherent risk free rate. 

If you are building multi family, warehousing, or office properties out in the suburbs, you’ll often find this ratio at play. You’ll find 90% of the capital cost is in constructing this new building. That building is the business performance risk. It may or may not work out long term, it may or may not exceed the next cycle and meet the expectations for the investors. And about the other value is in the dirt. So the dirt is about 10% of the value. The structure is worth 90% of the cost to develop it in a suburb. And so you’ve got 90% at risk of business execution and business model.

Where To Find Different Models

If you look inside the urban interiors of the fastest growing cities, the healthy cities that are vibrant, you’ll find something almost inverted to that. You’ll find that the property values will often be 75% – 90% of the total stack and only about 10% – 25% of the development costs be in the actual structure, the preexisting structure. You have 15% at risk in the structure and the business model risk. You’ve got 85% of the investment in the land. And so you only have 15% exposure to the business model risk of that specific asset type.

Why to Think About Choosing Models

That is something really to be thinking about if you’re an LP investor and investing in syndication and sector specific performance vehicles. Risk is inherited in every asset type. But as you look for quality locations on great pieces of dirt, this risk is heavily mitigated and allows you to re-purpose the land for other uses. Again, suburban structures tend to be somewhat worthless pieces of dirt, where urban locations tend to be seemingly worthless buildings on very valuable dirt. Your risk perspective needs to allocate adequately to both scenarios. The business risk is inherent in every investment and LPs need to be very cognizant of that. And take that into account in their evaluations.