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Office buildings can be highly profitable and exciting real estate investments if purchased and structured properly. Office types range from single tenant buildings, such as corporate headquarters, to large office campuses and high rises with many tenants of different sizes.
Like many other real estate asset types, office buildings can be delineated by age and quality into different classes - class A, class B and class C. Class A projects are those of the highest quality and finish, typically new or newer, and are found in very strong locations such as downtown financial districts, commanding the highest rents.
Class B buildings are often older Class A projects, with good layouts and design, that might be found in secondary, or suburban locations. Rents for Class B buildings are often significantly lower than Class A buildings.
Class C projects are often quite older than Class A, and might even be mixed use, with retail on the ground floor, for example. They may have a relatively large number of tenants due to their older design. They may still provide stable income, however. A large number of small office tenants could mean a more reliable income stream as well as lower T.I. costs, as smaller tenants tend to be less demanding when negotiating leases and may limit vacancy exposure.
Lease rent rates are the primary driver of value for office projects. Lease rates typically increase or decrease with economic cycles. On one hand, businesses must have office space in order to conduct their business, ensuring that generally there will always be some demand for office space. However, as an economy worsens, the pressure on many businesses to reduce office space use or simply go out of businesses can negatively impact the office space market in your metro area. Keep in mind that a 10% reduction in an office property's net rent collected drops a property's value by the same amount. A drop in value of this amount could mean that your equity in the property is significantly reduced. A lease with a tenant does not necessarily mitigate this risk. A long-term lease can provide you reliable income only as long as that tenant has the financial ability and willingness to pay the rent.
While leases are legally binding, enforcing a default on a lease can be costly and if the tenant does not have attachable assets, a legal judgement does not mean you will actually collect.The cost of enforcing a lease (legally) can be very costly. If your lease is to an entity that has no assets, you have no leverage. It is very important to income qualify your tenants, and if necessary determine the creditworthiness of the tenant regardless of their structure.
Conversely, if the economy is doing well and there is a low vacancy rate in the area in which you are considering investment, the return could be higher than is available from other real estate asset classes. However, it is important to understand the typical customs of that market. Who pays for tentant improvements, what is the typical leasing commission (leasing commissions are typically paid for the full term of the lease at the lease execution. So if the typical commission is 6%, and $20.00 per square foot is the “market” for TI’s you will pay 6% of the entire lease and the full amount of TI’s negotiated prior to receiving any income. Imagine that the lease rate is $20.00/square foot with 3% annual escalations on 1,000.00 square feet of office space for a 10 year lease. The total lease value is $229,227.58. Commissions due at lease execution will be $13,756.65 and TI’s will cost you $20,000.00. Prior to receiving any rent you will pay $33, 765.00 out of pocket. (not including legal expenses, which are often necessary when negotiating commercial leases). You will receive a total of $193,854.25 over the next 10 years assuming the tenant honors the terms of the lease. It will take over 20 months before receive real cash flow is received from this lease.
This is why it is critical that you create a reserve account for TI’s commissions, vacancy, and associated costs.
Notably, certain locations tend to always be in demand regardless of economic conditions, mitigating lease risk to a large degree in such locations. However in the last 5 years even national credit tenants have defaulted on leases. They often have extensive legal departments and the cost of enforcing leases may not make economic sense.
As NOI is largely dictated by the amount of expenses the property generates, the type of leases in place when you acquire the project is also an important consideration. There are three primary types of office leases - a gross lease, a modified gross lease and and a triple net lease. Gross leases require that the tenant only pay the lease rent, with the landlord responsible for all property- related expenses. Conversely, a triple net lease requires that the tenant pay all property expenses, including their proportional share of property taxes and insurance and CAM, (common area maintenance, sometimes used interchangeably as the NNN). A modified gross lease, in turn, dictates that the landlord and tenant split the expenses in some negotiated fashion.
Keep in mind that, although a triple net lease may sound most attractive, their lease rates are often above market when all expenses are added, artificially inflating a property's value, so your analysis must account for this.
it is very important that you audit the leases and receive estopple certificates prior to purchase to determine the cash implication of the terms and the fiscal health and viability of the tenant.
Keep in mind that the tenant may not ultimately be able to pay the additional expenses, or may not maintain the building in the condition that you the owner may prefer, if it is not explicitly outlined in the lease. This is why it is important to make sure the leases contain stipulations and penalties to the tenant if its requirements are not met.
In terms of occupancy, those office investments that have income in place will clearly provide a more stable income than those that do not have solid credit worth tenants. Such speculative projects may have particular opportunity. For example, if the office market within which a vacant building is found is very strong, then leasing the building could be a straightforward exercise and an opportunity to insert qualified and stable tenants and income. Keep in mind, though, that leases take time to negotiate and execute, and during that period there will be little or no income from the project, but you will need to pay the NNN expenses. In this case, you should also be buying the property at a deep discount from what it would be worth if it was fully occupied, to compensate you for the lease-up risk and give you a high return for your efforts once leased.
As discussed above, in most markets, tenants will expect you to pay for a certain level of tenant improvements - office divisions, walls, carpets and so on. You should factor these improvements, or "T.I.s", as they're known, into your operating costs for the project and also set aside cash reserves to pay for them to lure potential tenants to the project in the future. When evaluating a building for investment, careful consideration of how equipped it is for new tenants - flexible existing space, upgraded systems, general condition of the property and maintenance history, for example - is important.
Valuation based on a project's income is probably the most important method of determining an office investment's viability. One totals the property's gross income from all of the leases in place and then deducts the property's expenses, which include building taxes, insurance, utilities if paid by the landlord, maintenance and so on. The result is the net operating income, or NOI. the NOI is then divided by a capitalization rate, or Cap Rate, to determine value.
The Cap Rate is similar to a rate of return, or return on investment, that one might expect to achieve on comparable investments or properties. If a property's NOI is $100k, for example, and the Cap Rate is 10%, then $100k divided by 10% is the value of the property -or $1million. Cap Rates vary widely depending on Class of property, quality of location and tenancy. Consequently understanding recent sales and lease rental rates of comparable office projects is very important in determining appropriate expectations for return on a particular investment.