Understanding the 'Build-to-Core' Strategy

In commercial real estate, investing in a "core" asset is considered a safe, relatively low-risk venture. It typically involves buying a well-located, high-quality building that is fully leased to one or more credit-worthy tenants for reasonably long lease terms. Such a building is often relatively new, meaning maintenance and capital costs for the property are low.

Core properties are highly sought after as they are stable assets that produce reliable cash flow; this means they can also often be challenging to acquire. When the market for core real estate assets becomes particularly competitive, prices can rise to such an extent that the price of a typical core asset exceeds its "replacement cost." In other words, the property would now be cheaper to develop and build from scratch than to purchase as is.

When this scenario occurs, some investors employ a strategy called "build-to-core." The essence of the approach is that the process of developing a building (i.e., buying land, obtaining entitlements, securing financing, erecting a structure and leasing it) is less costly than paying for a comparable existing asset. So, rather than buying a building, an investor turns to a developer that can construct and lease one up.

Pricing Risk

The irony, of course, is that an investor seeking a core or very low-risk property is undertaking a highly fraught process to obtain one.

"Normally, with a core investment, the construction risk is already done, and you have leases in place with stable cash flow," said Gabriel Silverstein, national chair for institutional capital markets at SVN Commercial Realty. But investors look at the gap between what it costs to buy and to build, and they assess that building will give them a lower cost basis, he said.

Over the past ten years or so, the build-to-core strategy has been prevalent relative to industrial assets. Investment capital has been ravenous for industrial deals, Silverstein said, resulting in struggles to find deals at pricing investors like. "So, in order to place capital, they start to take risks that some don't fully price into their [investment] model."

Whether it's investor money behind a developer or direct investment from a developer, a glut of capital has been seeking industrial properties. This has resulted in very low cap rates coupled with development risk, Silverstein said, leading some to ignore the amount of risk they take to obtain a core property.

Investor Plus Merchant Builder Equals Success

"I think the biggest risk associated with build-to-core is whether or not you have the development expertise," said Grant Pruitt, managing director at Whitebox Real Estate, headquartered in Dallas. Accordingly, selecting a development partner with extensive experience in the particular market and asset class is key.

The concept of build-to-core is also only valid if the investor has enough capital to cover unanticipated expenses, such as higher than expected construction costs or a longer lease-up phase.

"Historically you had the merchant developer that had the know-how to build the product, and then you had the people that more or less wanted an annuity as a long-term cash flow, that would buy and hold it. Now it's the merger of those two," Pruitt said.

Key Market Conditions for Build-to-Core Success

For the build-to-core strategy to be successful, several key market conditions must be in place, essentially simultaneously. The market conditions most relevant to the success of build-to-core include:

• Robust demand from tenants. For a developer to have the confidence to break ground on an asset without a full or partial prelease in place, they must be confident they will secure a tenant while the building is under construction. Declining vacancy rates, rising rents and a robust pipeline of credit-worthy tenants seeking to lease space are all indicators of strong demand.
• Limited supply of the asset type in question. Examining the development and construction pipelines to determine how many projects have been entitled or broken ground can indicate how much or how little supply is coming to the market. Developers that own land that has already been zoned for the desired use typically have a significant advantage over those purchasing land and seeking entitlements, because the former can break ground more quickly. Most investors willing to participate in a build-to-core strategy will commit their capital to projects only if they have been fully entitled and construction permits are in hand, so groundbreaking can occur immediately, before market conditions change.
• Robust amounts of capital and demand from investors. Just as there must be deep demand from tenants, there must also be robust interest from investors seeking to purchase similar properties. Significant amounts of capital earmarked for a particular asset class, inside a limited time frame, puts more pressure on investors to find projects, making the build-to-core approach to ownership attractive.
• Stable costs. The gap between price and replacement cost is the key figure developers are leveraging. So, ensuring this gap endures over the 12 to 18 months it takes to construct a building is critical for this strategy to work. If finance, construction or other costs increase unexpectedly over this period, an investor may find their anticipated return has eroded or disappeared.

Build-to-Core Definitions Can Vary

Pruitt noted that beyond the above-mentioned circumstances relating to hyper demand and overheated markets, there are "a bunch of different interpretations of the build-to-core strategy."

He said that the term build-to-core can also be used by a merchant developer that builds and leases a property and then sells it to an investor that will hold and operate it in perpetuity. This is essentially the traditional real estate development process pioneered by companies like Trammel Crow in the early years of the development industry.

"My sneaking suspicion is that you would be hard-pressed to find many [institutional investors] with true soup to nuts, build-to-core strategy funds. They're all going to have some sort of hybrid or some sort of blend with different product types along the way," Pruitt said.

"Maybe 75% of their product or 60% of their product is true build-to-core … or [maybe they are] buying a park that has two buildings and another bit of land that could be developed," he said. In other cases, Pruitt said they are indeed land banking sites, positioning themselves for future build-to-core opportunities.

This article was updated on 12/13/2024