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October 16, 2007
The "Shell" Game
Is time running out on the popular strategy involving development and sales of shell buildings?
Three shells and a pea. You don’t see much of that old confidence game in Chicago anymore. But there is another shell game of sorts—this one completely legal—that has been embraced by industrial real estate players throughout the Chicagoland area and elsewhere.
Developing industrial product to varying degrees of finish has had strong appeal to investors seeking entry or expansion in the vibrant Chicagoland market. This has been particularly popular around land-constrained O’Hare and in other submarkets sporting strong fundamentals. It’s been a convenient strategy for both buyers and sellers for several years.
On one hand developers use the shell concept to facilitate and expedite their exit strategy. It is not uncommon for developers to price shell buildings with no tenant commitments at cap rates approximately 50 basis points lower than similar deals with no leasing risk. This allows developers the opportunity to cash out quickly and avoid the costs and risks of holding and leasing a project through fruition.
At the same time there has been robust demand for shell buildings. Institutional investors have allocated ample capital for these types of value-added deals that target vacant buildings and offer the potential for higher returns. By sharing the leasing risk with the developer, the buyer hopes to achieve a more opportunistic yield upon successful leasing. JP Morgan Chase recently announced just such an acquisition in Libertyville, while ING has invested in shell buildings in both the O’Hare and Lake County submarkets.
In some cases sellers package a shell building with more fully leased product, thereby creating some level of income across the entire portfolio. There have been many iterations of this strategy, with creative deals structured in ways that adjust the risk-return balance to an appropriate level for the specific buyer.
The End of Easy Money
Certainly this strategy has proliferated in recent years and has proven successful. But has all the easy credit and ample capital chasing opportunistic yields created a false sense of security? When the global credit markets abruptly change as they did this past summer, deals begin to be re-evaluated. Developers expecting institutional investors to shoulder some of the leasing risk associated with shell developments may find themselves having to carry a vacant building indefinitely. Buyers for these deals could become harder to find, and the risks will be exacerbated by any economic slowdown.
For the moment there still seems to be plenty of institutional money on the sidelines waiting to be placed. The value-added opportunities offered by these developments may still have room to run. However, this shell game will have limitations, especially given the credit turmoil seen in the summer of 2007.
At some point investors could lose their appetite for the added leasing risks associated with shell buildings, especially given the huge amount of new industrial space coming on-line in many Chicago-area markets in 2008 and 2009. At a minimum, there could be a repricing of risk that will necessitate developers to give up more of their returns for such a project. How much will the spread grow? That remains to be seen.
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