A Risky Bet in Charlotte

How’s this for positive thinking?

In Charlotte, N.C.’s biggest office-property sale since the downturn, an investment unit of Cargill Inc. has teamed up with two Goldman Sachs Group Inc. veterans to buy a 997,000-square-foot office park in a suburban market that has a nearly one-third vacancy rate.

The venture of CarVal Investors and Vision Equities of Mountain Lakes, N.J., last month bought Coliseum Centre, just southeast of Charlotte Douglas International Airport, in a deal valued at $103.2 million. That market’s office vacancy rate rose to 31% in the first quarter, up from 29% in the year earlier period, according to CBRE Group Inc.

Coliseum Centre, a six-building complex on 66 acres named for its proximity to the National Basketball Association Charlotte Hornets’ former arena that was torn down in 2007, itself is 19% vacant. Also worrisome: Leases for another 150,000 square feet of its space expire over the next five years.

But an analysis of the deal indicates it may not be so risky after all. It clearly has big perils for Vision and CarVal, which manages real-estate assets for the closely held grain-marketing company as well as other investors. The region’s economy has suffered from the contraction of major employers and other strains from the downturn. Bank of America Corp., which employs about 15,000 people in the Charlotte area, last year said it would cut 30,000 jobs over three years in its consumer-banking divisions. It also plans to eliminate 2,000 jobs in its investment bank and other units.

But given the deal’s low price and attractive debt terms, only a few things have to go right for the venture to hit its return objective: a compounded annual rate of return on equity of between the high teens and 20% over the investment’s life span. The venture likely would sell the property within three to five years, the new owners said.

“If you don’t want to take a risk, you shouldn’t be in real estate,” said Fred Arena, a former managing director at Goldman who formed Vision Equities with Sam Morreale in 2006.

For starters, Coliseum Centre’s annual net income of about $8.7 million represents an initial yield of 8.4% on the total price the venture paid. That isn’t bad considering the yields on deals in markets such as New York and Washington, D.C., are in the 5% range.

The venture’s strategy also is being fueled by the sweet debt deal it worked out. About $34.7 million of the purchase price was in cash and the rest came in the form of a $68.5 million mortgage from¬†Bank of America Corp.,¬†with an interest rate in the 3% range. That means that after paying debt service, the venture’s leveraged return on equity is in the high teens.

The danger is that the property’s income falls and values of the nation’s suburban office properties continue to decline. The office market near the airport has suffered as new supply has been added in recent years, and it also is competing for tenants with newer suburban office markets. Some of the building’s cash flow will have to be used to pay for commissions, interior construction and other incentives, which come to an average of about $20 a square foot in that market, brokers said.

But Mr. Arena of Vision said prime space in the office market near the airport has a healthier vacancy rate in the 20% range. He also says he will target cost-conscious tenants in Charlotte’s central business district or elsewhere, where prime space can cost several dollars more a year than the $18.50 he is asking.

If the venture’s leasing strategy is successful, the property could sell for a big profit in a few years. For example, consider what would happen if the venture is able to increase the property’s net income to $10 million a year. Even if values stay the same, and buyers continue to expect an initial 8.4% yield, the property could sell for about $119 million.

If values rise to the point that investors expect a lower yield of, say 8%, the property could fetch about $125 million. That would represent a $22 million profit on the venture’s $34.7 million initial investment.

CarVal and Vision Equities executives are betting their plan will be helped by an improving Charlotte office market. “The property is entirely institutional quality. It simply sits in a market that the institutions haven’t determined it’s safe to go back into,” said Bob Perry, senior managing director of CarVal Investors.

But he said that provides opportunity: “You go where the puck is headed, not where it is today,” he said.

The venture purchased the property from a unit of J.P. Morgan Chase & Co., which was represented in the deal by Ryan Clutter and Patrick Gildea of CBRE Group. The buildings were built and purchased by J.P. Morgan in the 1990s and early 2000s, costing an overall average price of about $110 a square foot, according to people familiar with the matter. In comparison, CarVal-Vision paid $103 a square foot. J.P. Morgan declined to comment.