Build-to-core is a real estate strategy that is defined as developing a project from the ground up (“build”) and then holding the stabilized (“core”) property for the long-term. Wealth is created during the ground up development phase and then, following, the asset transitions to delivering a high yield passive income stream. This is a popular strategy utilized by pension funds, family offices, public REITs and insurance companies to maximize both appreciation and cash flow.
Over the years, our investors have enjoyed the returns we’ve made for them, but many have also expressed their desire to stay in deals longer to minimize taxes and benefit from the passive income. We’ve learned that you never sell quality real estate. More wealth has been made through a buy and hold strategy, and the high yield income stream that grows every year generally outpaces inflation by a wide margin.
The build-to-core strategy achieves the two biggest goals of real estate investing, growth and income, with a single vehicle. The purpose of a ground up build is to create substantial value to equity through the development process. In a typical project leveraged at 65%, an investor would expect to double their equity over the first four to five years and build a cash flowing asset that generates an annual cash-on-cash return of more than 8% once stabilized. In the first two years of a development, the cash flow will be negative due to interest accruing and receiving no revenue. Starting in year three, the property will begin to generate cash flow as leasing begins and will generally be stabilized by year four.
Benefit #3: Enter Red Hot Markets at a Better Basis
Build-to-core is a great way to enter red hot markets where existing product is trading at or above replacement cost. In places like Phoenix, Nashville and Orlando, it’s not uncommon for existing projects to trade at 10% or more above what it would cost to build today. A build-to-core strategy allows investors to enter these markets at a far better basis than buying an existing project. For example, if an existing property costs $260,000 per unit to buy but can be built for $230,000, the better strategy probably is to build.
Benefit #4: Downside Protection
The greatest investing risk always lies in the things we can’t control. We can define where we want to buy, which property we acquire, perform exhaustive due diligence, and negotiate every last penny but market forces can easily overwhelm even the most disciplined investor. The good news is that appreciation acts as a cushion against loss during the ground up development process.
For example, if a project costs $60 million to build and is worth $70 million when complete, the property’s value can deteriorate to $60 million before the initial investment is at risk. It’s not ideal to invest for three years and not make any money, but it’s still not a bad outcome if the market declines precipitously during that time.
In contrast, a stabilized project acquired with equity and debt wouldn’t do nearly as well under the same market circumstances because it lacks the equity cushion. For example, if a property is purchased for $70 million using $30 million of equity and $40 million of debt, and the value deteriorates by $10 million, the loss is borne 100% by the invested capital because there is no profit cushion.
Benefit #5: Reduce Taxes
Capital gains is a tax paid when you sell an asset that has increased in value. Today, the Nation’s highest earners are subject to maximum tax rate of 23.8% on long-term capital gains. Recently, President Biden proposed treating long-term capital gains like ordinary income for America’s highest earners, which means that taxes on capital gains could nearly double to as high as 39.6% for Americans earning over $1 million per year. In today’s environment where taxes are likely going up, the tax implications of an investment must be considered. If a ground up development project is complete and then sold, you will owe a substantial amount in taxes, thereby reducing the amount of equity you have to invest in the next project. The build-to-core strategy avoids this issue, taking full advantage of depreciation and the ability to refinance tax-free.
Benefit #6: Reduces Cash Drag
Cash drag is defined as money sitting idle in your bank account while it is waiting to be deployed into a private real estate investment. If a ground up development project is complete and then sold, the money returns to your bank account. From there, it may take you three to six months before you are able to redeploy that capital. This idle period is rarely ever considered, but when included in the overall investment return calculation, a great return can suddenly look mediocre.
Build-to-Core with the Origin IncomePlus Fund
The Origin IncomePlus Fund will invest 20% of the Fund’s capital into build-to-core projects. The rest of the Fund’s portfolio will be comprised of 25% debt investments (income-producing preferred equity and mezzanine debt positions) and we’ll continue to pursue core plus opportunities with the rest of the capital, so long as they can withstand our rigorous underwriting criteria. In a market that’s flush with capital, buying existing core plus assets at a price where we can get the best returns for our investors is extremely challenging. Our barbell approach of developing and lending in today’s competitive market mitigates risk without sacrificing returns for our investors.