Commercial Real Estateinvestment

Growers, Sustainers and Eroders

There was this interesting article in the Financial Times (FT) that described firms on the stock market as growers, sustainers or eroders. The article is an examination of how the American economy has undergone a shift as the proportion of these types of firms has changed over the years.

The Grower Sustainer Eroder Mental Model

 The mental model the author created distinguishes on capital invested is as follows:

  1.   A Grower is a firm with capital expenditures in excess of earnings before interest, taxes, depreciation, and amortization (EBITA) which taps capital markets to finance investments.
  2.  A Sustainer is a firm that makes capital expenditures greater than its consumption of fixed capital and also returns cash to shareholders, with EBITDA sufficient to do both.
  3.  An Eroder is a firm that consumes its fixed capital faster than it makes new capital expenditures, while still returning cash to its shareholders, though its EBITDA would be sufficient to replenish its capital base.

You can find that FT article here. The original paper of the author is posted here, as I am certain we will not do his argument justice.

What struck me while reading it is that this mental model – growers, sustainers and eroders – has really good applicability to commercial real estate investors. It could help identify how various life cycles that affect real estate interact begin to align with the interests of growers, sustainers and eroders.

Commercial Real Estate Forces undermining investment

Real estate investing is about buying and maintaining and upgrading buildings, and how those buildings can attract tenants paying rent. Eventually all building are acted upon by three sets of obsolescence as they age.

The first is physical obsolescence: as building systems – roof, HVAC, electrical, elevators, common areas, operational systems, etc – get to the end of their economic life and need replacement.

The second is functional obsolescence: the tenant demand design criteria that made them ideal at one time do not work as well anymore. Examples include: clear height and dock requirements for logistics firms; or ideal floor design to adopt to the most recent new thing for office furniture, IT layout and access to natural light; or retailers switching from insisting on an end-cap location to insisting on a pad with a drive-through location.

The last and most insidious is locational obsolescence: the neighbourhood has changed and what used to be the right use in the right spot and is no longer. The real estate cannot just be refreshened, it needs to be repurposed or demolished. I always wondered what showed up first, the artists creating new and funky boutiques in a neighbourhood that is experiencing gentrification, or cheap rent. With this model, likely physical, functional, and locational obsolescence combine to drive the cheap rents necessary to spark gentrification for those artists to find and populate.

Mapping the model onto the commercial real estate world

The proposed model speaks to a category that applies to the firm as a whole. I will use the model to describe what happens at an individual property level. What I believe it helps with is uncovering I imagine this mental model makes the following transformation into commercial real estate:

·       Growers are developers, providing new or redeveloped buildings;

·       Sustainers are those who buy from developers, and they invest capital into the buildings to postpone or delay obsolescence; and

·       Eroders are who buy from sustainers or other eroders, as sustainers exit before the property experiences too many obsolescences, and eroders run the property to maintain cash flow distributions to investors and ignore/delay/avoid capital investments; and

·       developers buy from eroders when it is time to demolish or redevelop.

Commercial real estate investment simplified: Investors are growers, sustainers or eroders. It may make life easier to sort out which one you are for any particular investment opportunity.

Keeping in mind that all models are wrong but some are useful, does this help explain some market players and trends?

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