10.5 Special purpose properties

Special purpose properties are unique real estate assets designed for specific uses, like hospitals, theaters, or schools. These properties have customized designs and narrow tenant pools, making them riskier investments than traditional commercial real estate.

Investing in special purpose properties comes with challenges like higher vacancy risks and specialized maintenance needs. Financing often requires larger down payments and shorter loan terms. Valuation can be tricky, using cost, sales comparison, and income capitalization approaches.

Types of special purpose properties

• Special purpose properties are designed and built for a specific use or industry, differing from traditional commercial real estate (office, retail, industrial, multifamily)
• Examples include healthcare facilities (hospitals, medical offices, senior housing), entertainment venues (theaters, sports arenas, museums), educational institutions (schools, universities, libraries), and religious buildings (churches, temples, mosques)
• Other specialized properties include self-storage facilities, car washes, marinas, and golf courses, each with unique physical characteristics and market dynamics

Unique characteristics of special purpose properties

• Often feature highly customized designs, layouts, and building systems tailored to their specific use, which can limit flexibility for alternative uses or tenants
• May require specialized knowledge and expertise to operate, maintain, and manage effectively
• Typically have a narrower pool of potential tenants or buyers compared to traditional commercial properties, as they serve a specific industry or market niche
• Can be more sensitive to economic, demographic, and regulatory changes that impact their specific sector or use

Risks of investing in special purpose properties

Higher vacancy risk

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• Limited pool of potential tenants can lead to longer periods of vacancy and lower occupancy rates during market downturns or when a tenant vacates
• Specialized design and layout may require significant renovations or adaptations to attract new tenants, increasing costs and prolonging vacancy
• Dependence on specific industries or sectors can make properties more vulnerable to economic shifts or disruptions (e.g., a decline in the healthcare industry affecting medical office properties)

Specialized maintenance requirements

• Unique building systems, equipment, and finishes may require specialized maintenance and repair services, which can be more costly and harder to source compared to traditional properties
• Compliance with industry-specific regulations and standards (such as healthcare or educational facilities) can add complexity and expense to maintenance and operations
• Failure to properly maintain specialized features can lead to accelerated depreciation, reduced functionality, and lower property values

Dependence on specific tenants

• Many special purpose properties are built-to-suit for a single tenant or owner-occupier, making the property's performance heavily reliant on that tenant's success and continued occupancy
• Tenant bankruptcy, downsizing, or relocation can have a significant impact on the property's cash flow and value, as finding a replacement tenant may be challenging and time-consuming
• Long-term leases with specific tenants can provide stability but may also limit flexibility to adapt to changing market conditions or pursue value-add opportunities

Financing options for special purpose properties

Traditional lenders vs specialized lenders

• Traditional lenders (banks, credit unions) may be less familiar with special purpose properties and view them as higher risk, leading to more stringent underwriting and less favorable loan terms
• Specialized lenders, such as those focused on healthcare, education, or entertainment sectors, may have a better understanding of the unique characteristics and financing needs of special purpose properties
• Government-sponsored programs (HUD, SBA) or tax-exempt bond financing may be available for certain types of special purpose properties, such as affordable housing or community facilities

Higher down payment requirements

• Lenders may require higher down payments (30-40% or more) for special purpose properties compared to traditional commercial properties (20-25%) to mitigate perceived risk
• Larger equity contributions can strain investors' capital resources and limit their ability to diversify their portfolios or pursue multiple projects simultaneously
• Higher down payments can also reduce leveraged returns and make it more challenging to achieve target IRRs

Shorter loan terms

• Lenders may offer shorter loan terms (5-10 years) for special purpose properties compared to traditional commercial properties (10-25 years) to limit their long-term exposure to specialized assets
• Shorter terms can result in higher debt service payments and refinancing risk, as investors may face less favorable market conditions or lending terms when the loan matures
• More frequent refinancing can also increase transaction costs and administrative burdens for investors

Valuation approaches for special purpose properties

Cost approach

• Estimates property value based on the cost to replace the improvements (buildings, structures) plus the value of the land
• Particularly relevant for newer or highly specialized properties where comparable sales or rental data may be limited
• Considers factors such as construction costs, depreciation, functional obsolescence, and external obsolescence (e.g., changes in market demand or regulations)

Sales comparison approach

• Estimates property value based on recent sales of similar properties in the same market, adjusting for differences in size, age, location, and features
• Can be challenging for special purpose properties due to the scarcity of truly comparable sales, requiring a broader search geography or more subjective adjustments
• May be more applicable for properties with a relatively active market and consistent demand, such as self-storage facilities or medical office buildings

Income capitalization approach

• Estimates property value based on its expected future cash flows, discounted to present value using a capitalization rate (cap rate) that reflects the risk and growth potential of the income stream
• Requires reliable data on market rents, occupancy rates, operating expenses, and cap rates for similar properties in the market
• May involve more complex lease structures (e.g., triple net leases) or tenant-specific considerations that affect the stability and growth of the income stream

Lease structures for special purpose properties

Triple net leases

• Tenant is responsible for paying property taxes, insurance, and maintenance costs (the "three nets") in addition to base rent
• Commonly used for properties with a single tenant or owner-occupier, such as freestanding retail, industrial, or healthcare facilities
• Provides a more predictable and stable income stream for the landlord but may result in lower rental rates and longer lease terms

Gross leases

• Landlord is responsible for paying property taxes, insurance, and maintenance costs, while the tenant pays a fixed rental amount
• More common in multi-tenant properties, such as office buildings or shopping centers, where the landlord has more control over operating expenses
• Can be more attractive to tenants but may expose the landlord to higher operating costs and fluctuations in net operating income

Modified gross leases

• Hybrid structure where the landlord and tenant share responsibility for certain operating expenses, such as utilities, janitorial services, or common area maintenance (CAM)
• Can be tailored to the specific needs and preferences of the parties, balancing the benefits and risks of triple net and gross leases
• May involve expense caps, base year provisions, or other mechanisms to allocate costs and incentivize efficient property management

Tax considerations for special purpose properties

Accelerated depreciation

• Certain special purpose properties may be eligible for accelerated depreciation schedules under the Modified Accelerated Cost Recovery System (MACRS), allowing investors to deduct a larger portion of the property's cost in the early years of ownership
• For example, qualified improvement property (QIP) placed in service after 2017 is eligible for 15-year depreciation and 100% bonus depreciation, which can significantly reduce taxable income and increase after-tax cash flows
• Investors should consult with tax professionals to determine the appropriate depreciation method and schedule for their specific property and situation

Tax credits for historic preservation

• Special purpose properties that are certified historic structures or located in designated historic districts may be eligible for federal and state tax credits for rehabilitation expenditures
• The Federal Historic Preservation Tax Incentives program offers a 20% tax credit for the rehabilitation of certified historic structures and a 10% tax credit for the rehabilitation of non-historic buildings built before 1936
• Many states offer additional tax credits (ranging from 5-25%) for historic preservation projects, which can be combined with the federal credits to enhance the financial feasibility and returns of adaptive reuse projects

Case studies of successful special purpose property investments

Adaptive reuse projects

• Converting a former industrial warehouse into a mixed-use development with loft apartments, creative office space, and retail (e.g., the Ponce City Market in Atlanta, a 2.1 million square foot mixed-use project that transformed a historic Sears distribution center)
• Repurposing a vacant school building into a senior housing community, leveraging the existing classrooms, auditorium, and recreational spaces (e.g., the Academy Square Senior Apartments in Greensburg, PA, which converted a former high school into 56 affordable senior housing units)

Niche market properties

• Developing a specialized medical office building to accommodate the unique needs of a growing healthcare provider, such as an ambulatory surgery center or imaging facility (e.g., the Shirley Ryan AbilityLab in Chicago, a 1.2 million square foot rehabilitation hospital with state-of-the-art research and clinical spaces)
• Acquiring a portfolio of self-storage facilities in underserved markets with strong demographic and economic growth, capitalizing on the increasing demand for storage space (e.g., CubeSmart's acquisition of 22 self-storage properties across 8 states in 2020, adding 1.7 million square feet to its portfolio)

Public-private partnerships

• Collaborating with a local government to redevelop a historic courthouse into a mixed-use project with government offices, retail, and community spaces (e.g., the Old Post Office in Washington, D.C., a $200 million redevelopment that transformed a vacant federal building into a luxury hotel, restaurants, and event spaces)
• Partnering with a university to develop and manage a new student housing complex, leveraging the institution's land, credit, and enrollment growth (e.g., the University of California, Davis' partnership with Greystar to develop and manage a 3,300-bed student housing project, the largest single student housing project in the U.S.)