128 - Profitable Pivot: Navigating the Shift to Retail Development

Today hosts Braden Cheek, Brian Duck and Joel Thompson discuss Criterion's recent transition to commercial development projects.

Ok. Whats up and welcome back to another episode of How To Invest in commercial real estate. And we have an awesome show today, Thanksgiving week. Yeah. So we're, we're recording this the week before Thanksgiving. So I hope everyone has an amazing Thanksgiving or had an amazing Thanksgiving if you're listening to this, um Hopefully we do too. By the way, I think I precluded this in the last show. Uh Cold Plunge is coming up uh probably next week. So we need to hurry up and do this. We want to make sure it's really cold for that next week. Cold plunge. Hey, by the way, nice hats, guys. If you want any merch uh hit us up. Yeah, I mean, it's kind of for investors. So if you want any merch, give us some money, you want any merch for free. Uh Yeah, but yeah, if you're an investor, uh we're sending a little care package out, so you'll get an email about it. Don't worry. Anyway, we're gonna get into the show. Um If you've been on the investor list or if you've listened to our podcast ever or basically, you know, our names, you know, we've been doing a ton of retail development deals this past year, which isn't our background.

We started doing a lot of, of course, multifamily with precision equity, but multi-tenant retail uh with criterion even a little bit of single tenant retail. But yeah, we've gotten into development and we get asked, well, why, why the shift guys? Um why do you, why are you doing so many development projects now? Yeah. So I would say criterion is a commercial real estate investment company. So like any investment company we're constantly looking for, for yield in, in the asset class that, that we kind of, you know, brand ourselves on which is real estate. I mean, it's not, it's not difficult. So we're looking for yield in real estate like everyone else and uh interest rates are insane. A lot of people are pivoting. A lot of people who aren't pivoting, just stopped buying. I mean, there's, there's tons of people who just aren't buying or haven't bought anything in a year. Um That's not super uncommon right now. So I would say the answer to that question is we're looking for, we're looking for yield because we like raising money, we like placing money in the marketplace and, and we think there's a good opportunity right now in this retail development sector. Um So that's why we're doing it. Well, the interest rates sort of forced our hands, right? Buying existing asset class.

Um The prices weren't going down but the interest rates were going up. And so we had to, like you said, we're a real estate investment company and we had to chase the business where it's at. Yeah. And I think the important thing here is we talk about it all the time that you're one idea away from a new income stream. You're one contact away uh from, you know, a whole new opportunity. And that's uh kind of what we ran into with new development. We did a lot of multi-tenant retail, we did a lot of multifamily. And so the new development wasn't really on our radar. In fact, it just felt inherently more risky because of the unknowns, right? We didn't know how it worked. We didn hadn't done a lot of uh ground up development. It seemed speculative and, and so we didn't really pursue it, but then we got involved as the LP on a few deals and got to know uh the development game a little bit and that's how that's helped us pivot in this high interest rate environment to doing more development deals. But today we wanted to talk about, well, how did you get comfortable with them? And, and why are you doing them? And, and what's kind of the, the return metric that you guys are looking at?

Yeah, I, I would say you said the answer to the, the, the question almost immediately, right? It's, we got involved as an LP in somebody else's deals because we realized we're not an expert in this space. Uh We wanted to partner with an expert in space and it, and it starts with, hey, you guys seem busy right now. What are you doing? What are you working on? And how can we add any value? How can we help? How can we get involved and people staying busy in retail development right now still need money, right? And it's what's something we preach all the time is we tell people, hey, if you don't quite understand it, partner with us, partner with someone who does, you know, we don't just say that we, that's actually what, how we got started in this. Yeah. So we had a good value proposition where we are sophisticated real estate investors. We have the ability to bring equity and we have the ability to bring debt and debt relationships and our balance sheet uh to the project to, to help get better debt. Um So that's a lot of value that can be added to a project, especially from the developer's standpoint or the leasing agents standpoint or the tenant rep standpoint standpoint who, you know, reps HTO and wants to do, you know, 20 of them a year. He doesn't have or they don't have, you know, two or three or $400,000 per deal for, for 20 deals.

They may, they may be able to do one or two themselves or five with friends and family or 10, asking everyone they know. But eventually they've ran out of, of people. So that's where we can kind of add some value. And then the more joint ventures and partnerships we've done the more value we've been able to add because we've been learning along the way. We've been asking better questions. We've been looking at sites and, and, and doing all these things um to where eventually, you know, we're doing more projects on our own and we're getting a bit more control and, and a bit more knowledgeable and, and less risk, you know. Uh I would like to think less risk along the way. Yeah, maybe we ought to go through kind of step by step because from the outside looking in, you know, when we were buying existing assets, it's, it's easy enough to say, oh, well, you know, it's kind of like buying a house. You go look at a property. You guys have talked about it a lot on the podcast, how you evaluate it, you go and make an offer and you buy it, but land development seems a little more complicated. So I think maybe if we went through it step by step, what, what is the first step in doing land development? Is it, is it finding a piece of land? Is it uh um getting some tenants who need some land?

What, what do you, what do you guys think is the very first step? First few steps, we're not tenant reps. So we're not actively looking for land for particular tenants. So I would say if you're like us, the key to start is to identify a piece of land in a good uh location, a good area of town, things are getting developed. And they've got a sign that says for, for, for sale and you call and they say, ok, that land is that land is $15 a foot, you know, or whatever, $20 a foot, $15 a foot really good area. And so now what do you do? Right. And, and for us, we, I wouldn't have known what to do uh before, but now I say, ok, I'm gonna tie that land up. I'm gonna try to tie that land up for four months, six months. Then I'm gonna go try to find uh national credit tenants that want to, to lease on that land that want to have their locations on that land. That would be step number one. So when you say you want to tie it up, you make an offer on it uh to the owner, they accept it and you put in the contract that you've got four months of due diligence or something just like that and they're willing to give that to you because they know what you have to do, right?

We, we wouldn't normally get four months of due diligence on an existing asset. Correct? Yeah, and you may even get way more than four months, you may get six months, you may get a lot less in a, in a tighter uh economy where it's more competitive and, and the sellers are making you perform. But right now, especially when nobody's closing on shit, you can lo it up for, for a while. As long as their ability of, of their belief of your ability to perform is high. But I, I think the big thing with development and, and the difference between development and an existing building is most people don't like. They, they may think they can, but they really don't understand that the commercial real estate investment game has nothing to do with the inherent building, right? And, and it's that inability of bifurcating what the two things are like, we know we're buying a piece of real estate, but the value isn't predicated on the piece of real estate. It's predicated on how much money the piece of real estate makes. So when you're finding a piece of land, you're, you're quickly running a highest and best use analysis like, OK, let's say it's the best piece of land ever and I could get a Starbucks and sell it on a five cap and, and get, you know, AAA $150,000 ground lease or something.

What does that get me? How much money is that? Is that $2 million? Is that 2.5 $3 million? And then you say, ok, well, this, this piece of land is $2 million. Ok. Well, that's probably almost out right there. So before you make the offer on the land, you've got to do all this, right? Because you gotta, you have to know what that land is worth, what kind of income you can get off the tenants that you can get in there. So you have to make a bunch of assumptions, don't, you have to also sort of lay out in your mind what, how many tenants you have and what size buildings and, and that you can put on that land. I mean, you've got to do all this before you make an offer, don't you? Exactly. That's what I'm talking about this highest and best use analysis. So, you know, we put together a team of people that can help do this for us. And the first one is just somebody who can lay a site plan out on the piece of land on Google Earth and say I can fit 15,000 square feet on the site. I can fit two pads on the site. I can fit, you know, a three tenant uh retail building and one ground lease on the site and just kind of give you a few options. And then the next phone call is to the leasing agent or whoever you think can get you these tenants and say, hey, you know, if I can get 9000 square feet you know, of, of retail space and a ground lease.

Do you think you have any interest in that or I have this piece of land? And the leasing agent may just tell you what the interest is and then you, you have to assume kind of a low, medium and high ground of, of what you think you could get again based on the conversations with the people in the area and the leasing agent and your, and your previous, you know, underlying assumption of why you thought this would be a good place in the first place and just say, ok, if I could get everything I wanted on this site, what would that be? What would I charge them in rent? And then you have to run an exit value right then and then you know how much money you can spend. Yeah, think about it this way. Let's say that I have an acre parcel that I want to put a Chipotle on. Ok. And let's say that I think the, the Chipotle will pay what 100 $100,000 a year uh for a ground lease. Sure. Sure. Ok. Uh What about uh a building? Yeah, a building. They're probably, you know, 40 or $50 a square foot in rent on a brand new. So that would be 100 and 60,000, let's say if it's a 4000 square foot, not too far off, not too far off.

Ok, let's just take, take some rough numbers. 4000 square feet. A brand new, uh, build a suit and a great part of the market could be $40 a foot. That's 100 and $60 100 and $60,000 of rent. What are Chipotle's going for? Five and three quarters. Yeah, five and three quarters. Six. It depends on the market. Let's just say we're in a good market and it's five and three quarters uh cap rate. So I'm dividing the 160,000 by a five and three quarter cap that gives me 2,800,000 as an exit value. Ok. Well, let's decide how much is the land. Uh the land could be $18 a foot and it's an acre. So 18 times 43 5 60 that's $785,000 for the land. Now, all we need to do at this stage, we know we have an exit of 28. Roughly, this is just rough numbers guys, uh 28 and we know the land's gonna cost us. Let's just call it 800,000. So, uh 28 and 800,000, we got uh 1.8 no, $2 million to build the building. Now, we don't want to build the building for 2 million because then it's just a break, even exercise for us.

Ok. But what if we could, we get the plans from Chipotle and we understand that their building costs $1.5 million. Now, we, we know that there's potentially a half a million dollars in there if we get that lease secured, we know that lease is enforceable, that gives us, uh, the confidence to close in the land and we've already gotten bids on their, their site plan. And so we just, you know, as long as the bids come in about 115, we do the deal and we end up with 4 to $500,000 of profit. Ok. Maybe I'm jumping the gun here. But when do you have Chipotle signed a contract that says that they're going to lease that building from you at what point before you? So yeah, they're kind of like two big practical, you know, umbrella schemes and then the the logistics of getting this done. So once you have it in contract, you, you're pitching the site or your tenant. We're not pitching the site to Chipotle. I don't know anybody at Chipotle, right? We hire leasing agents, right? This last uh Chipotle I did, I think um or we did, I think the shop company helped us. Maybe it was somebody else. But um it's always, always leasing agents, right?

So once we get a piece of land under contract, we're getting rough drawings, we're getting site plans, we're getting numbers on, on how much parking and everything like that, put it in a package, we're blasted out to the marketplace. And the leasing agent is saying, hey, so and so is interested. So and so is interested. So and so is interested and they're submitting Lois letters of intent to lease just saying, hey, if you could deliver me 3000 square feet with $50 a square foot in 10 improvement allowance, I'll sign a 10 year lease today with Chipotle credit and you kind of counter that back and forth until you get to a good number. We're trying to underwrite our unleveraged return on cost, which is just how much we think it it will cost total versus how much we think we can get in rent. That's the unleveraged return on cost. Um So it's really your positive leverage, right? We talk about positive leverage a lot on the show. The positive leverage in the arbitrage here is the difference between what we think the asset will sell for in the marketplace complete with the the tenant running. So using the same example that Chipotle that we think is gonna sell for a, a five and three quarter cap rate.

Let's just say it's in DFW, right? So, and we would want our unleveraged return on cost to be 200 to 250 basis points above that number and, and that 200 to 250 basis points may change based on the market you're in or, or whatever other risk you're adjusting. Well, go I was gonna say, ok, we started with an exit cap of 575 on the Chipotle. That means we need to build, uh, to an eight for, uh, a two and a quarter spread between the, the two. Correct? Ok. So then it's real easy. Let's go back to our $160,000 number. That's the income, the triple net income that we think we can get out of Chipotle if we build them a building. Well, all I've got to do instead of putting a 575 cap on that, which gives me a sale price of 2.8 million, I'm gonna put an eight cap on that number. Right. So I'm just gonna divide 100 and 60,000 by 0.08. And that's gonna tell me what my all in cost can be and that's 2 million dollars. Yes. So once we get this $2 million number, we've got that signed letter of intent from Chipotle.

We take this idea right to a contractor and hopefully it's not the first time you've talked to that contractor, right. Hopefully you've had some, if, then conversations with a lot of people before this point. But if you haven't, or even if you have the conversation goes similarly to this, hey, I've got a Chipotle, here's the plans. How much does it cost to build it? Ok. Give me a guaranteed maximum contract for that brit, that bid maybe $2 million or, or whatever it is. And you still haven't closed on the land yet, still haven't closed on the land yet. Land still in contract. The lease isn't signed. So you've just got an LO I so you go get that guaranteed maximum contract and the, and the bid from the contractor, you've got the LO I and, and hopefully the LO I is finalized and at this point, you say Chipotle, I'm ready for a lease draft, right? You'll turn that lease back and forth with comments 23 times, four times. It may take a month, it may take months to get that lease signed, but you really want to get that lease signed. So now you've got a guaranteed maximum contract, which is kind of downside protection for your cost on the unleveraged return on cost. You're working on the lease, which is the only other factor of the unleveraged return on cost, which is your income, right?

So you're working on both of those that pretty much sums up that equation and then you're just pushing the land on until hopefully the lease is signed. You get the guaranteed maximum contract signed. You've got a lender on board, right? Because you've got the guaranteed maximum contract from the contractor. So we know the building can be built for 2 million. We've got signed lease from Chipotle, so we know we can get 100 and $6000 in rent. The business plan is done. The, the lenders agreed and hopefully at this point, you can finally close on that piece of land. So let's go back to our example. You got $800,000 in the cost of the land. Let's say the building cost uh when we're dealing with a 4000 square foot building, let's say the building cost $250,000. Uh sorry, $250 a foot. Ok. And so that is a million dollars for the cost of the building. And then we're gonna give them, let's call it $50 in tenant improvement dollars, $50 a foot. So that's another couple 100 grand. So you got 800,000 for the land, you have a million dollars for the base building. That's 1.8. Then you have 200,000 in T I dollars for the tenant for interior uh upgrades. That's $2 million.

And we've already said that if we have 100 and 60,000 in rent, which is $40 a foot that we can get a $2.8 million exit, which is the a cap that we wanted, right? Versus the 575 that we're selling for. So that 800,000 is the spread that we want to try to make. Now you say man, that's a lot of profitt. Yes, it is because you have to have a decent amount of profit because everything that's gonna gonna go wrong could go wrong. You have over-budget you have, of course, you haven't talked about the debt yet. We haven't talked about the soft cost, the interest carry the leasing commission, the development fees. So there's all those things eat into that and we still have to have enough left over to pay the investors a return. And so that, that's kind of how this thing goes. But once we have those base numbers done, that gives us the confidence to, to move, to move ahead. Yeah, so it's it's a different form of yield, right? The the cash flow and retail shopping centers is a combination of a dividend that's paid out quarterly via cash flow excess cash flow. Just profit month over month, we pay that out every quarter of the investor. Typically that's about 10% and then the other 10% of the return, what we strive to be another 10% of the return is a combination of two things, rent growth, forcing appreciation on the property and then principal deduction by us paying our mortgage every month.

So this is we're underwriting to the exact same yield. We actually end up underwriting better. Again, we're trying to always underwrite to about 20%. Would you guys say 20% is a good number? I mean, give or take a few points of that. But these development deals, a lot of them are penciling mid twenties, a lot of them pencil higher than that. On the best case scenario, a lot of them are are maybe 18 on the low side. Um worst case scenario. Um but it's, it's just paid out like the arbitrage is so simple, right? And, and it's really the cost to build a building, the cost to build a building, the value of a Chipotle lease equals profit. Like the cost to build a building or the value of a Chipotle lease minus the cost to build a building equals your profit. Like it's, it's, it's so simple. So as long as you have a great contractor that you can trust to keep you in budget, that's got a guaranteed maximum contract. That that is step number one, step, number two, the national credit leases the credit, right? You two things guys first, you gotta have the credit uh in order to have the confidence to move forward, what is credit, credit means they're reliable and that they're not going to default on that lease.

You can't go tie up a piece of land and, and get a local mom and pop. You know, Joe's childcare, a jewelry store, you know, whatever that's selling trinkets, that's not gonna be strong enough and you actually don't know what that's gonna sell for in the market. The great thing about the national credit is if worst case goes, you can't sell it, you know, they're gonna pay that rent and that rent's enough to cover your debt service. But two, you know, you should know approximately where that's gonna sell at in the market, right? What cap rate on income is that gonna sell at? So it gives you confidence to know, ok, if I build this for 2 million and I have some soft costs and I have some develop P and all that, but I, if I get 28, I'm gonna walk away from this thing with some profit. And that's the, that's the security that we needed in order to start doing these deals. And now we're in a bunch of them because we're, we're, we're locking up national credit tenants in really good locations and we're gonna be able to exit for profit uh for our investor. And if you watch our last show, we've got a bunch of them coming up that are, that are gonna sell over the next few months, right? Yeah. Yeah. Yeah. A ton of them. Um One thing I wanna say when, when institutional investors are talking about the return, you'll, you hear you will hear a term used called discount rate.

And discount rate is kind of an epiphany for me when I was learning about this because we use discount rate or irr or yield all synonymous synonymously. But discount rate is fascinating because when you think about it, you're willing to accept different levels of return based on how much risk you're associating to it, right? So when, when you see something as super safe, you're like, I can't, I can't discount that much. You know, it's super safe. It's always gonna be there. It's there every month, every month. I check the first that's in my mailbox. I can't discount that much. There's no risk associated to it. That's Chipotle, that's Starbucks. Right. They're gonna pay the rent. If they don't, you're gonna sue them and win. Very simple. Uh, uh, another form of risk is we buy tons of shopping centers. Right. So, if you like these tenants maybe have half a million to a million dollars in sales in a store, they may only have one store, they may have a personal guarantee with like a home and their retirement account, uh guaranteeing it. So you don't have any credit if the business fails, typically their life is failing, they may be declaring bankruptcy.

There's not a lot of recourse for you to go after and their life is failing. Life is over a lot of the times it is if they're not paying the rent and they're one business, I mean, it's, it's bad. But if you aggregate enough of those, like if you can get 50 or 70 or 100,000 square feet of those, you know, credit profile tenants and then you have the leases rolling, you know, over a period of time or a long period of time, you, you can kind of discount that to around an eight cap and, and that's what we're typically buying. But because we're, we're getting such better credit, uh you know, uh, salad and go seven brew Chipotle Starbucks, uh, learning experience there. There's amazing credit we're going after and developing for right now, the buyer, right, that we're selling it to is discounting it way less. Right. Yeah. Yeah. So I think the, the point of the show and we're gonna wrap it up is that we were doing shopping centers, we were doing multifamily and because we were willing to take a risk and be an investor on uh retail development, we're starting to learn that game. And now we're able to offer those opportunities to our investors.

And what we found is that like everything, it's not that complicated and it's not that difficult once you get in and you understand it, the only reason it seems risky uh to an outsider is because they're lacking the knowledge and experience that that others have. And then we were lacking that knowledge and experience. But once we started to partner with those that did have it, then we began to see how the process goes. And so we always want to encourage you guys to dive in. Even things seem risky. They seem complicated. It really isn't uh that difficult. Uh Once you learn it, it's like, oh wow, this is simple, you know, to do a development, all I need to do is type a piece of land and then I need to find uh a leasing agent that wants to bring Chipotle into the market. And I'm gonna back of the napkin, figure this thing out and then I'm, you know, if you need equity, you're gonna call us, if you need a loan, we're gonna, we're gonna maybe suggest a lender for you. But anyway, that, that's just we want you to realize that that's part of, that's how every part of real estate goes. And we haven't done office warehouses yet, but we've looked at it and there's gonna be a time when we've done those and, and we're developing new apartments. Uh, that's, that's new for us. Each time you do something new, it's uncomfortable and you're gonna feel that it's risky. But once you gather the experience, it's gonna become second nature to you and then you move on to the next thing I was just thinking that this is probably the exact same thing that that guy said when he built the submarine and took everyone to the bottom of the ocean.

Like this is so easy. We just get a Playstation remote and, and some metal, we put some steel together and weld it in there and then we go crush our souls at the bottom of the ocean. All right guys. Uh, we want you guys to know we've answered the question. Why are you guys getting into so many new development deals? Uh Hopefully you, you got that and hopefully we keep rolling them out for you in the next new year. All right. Well, thank you. Hope everyone had an amazing Thanksgiving and we will catch you next week on how to invest in commercial real estate. Thanks guys.