Distinct asset classes categorize commercial real estate properties. Each asset class has differences that make an investment in a given property unique. This article will review the office asset class, which includes single and multi-tenant buildings ranging from small and single-storied to massive high-rise skyscrapers. Regardless of the type of office property, below are some considerations and tips to keep in mind when evaluating your next office property investment:
Not all Buildings are Created Equal
Most traditional office buildings are generally classified into one of three categories: Class A, B, or C properties. Class A represents the newest and nicest buildings, and they tend to have the most amenities and are positioned in desirable locations. On the opposite end of the spectrum, Class C buildings tend to be older, are usually not as well located, and lack the amenities and aesthetics of Class A and even B properties. Classifications can be subjective and vary from market to market, but knowing a building’s class can be relevant to an investor’s underwriting. If an investor evaluates a Class A building, they can expect to attract the best quality tenants and command the highest rents. However, it’s essential to keep in mind that high-caliber tenants will expect a very well-appointed property that is kept up to date and professionally managed. Investors may want to underwrite for higher operational costs as well.
Conversely, Class C buildings typically do not attract the market’s cream of the crop tenants, and the rents will most likely be at the lower end of the market. While tenants at Class C properties certainly want safe and clean properties, they also understand they are not getting the frills of a higher-class building, so there are opportunities to reduce operational costs. Additionally, tenants at Class C buildings are generally not expecting the same incentive packages to attract tenants (i.e., tenant improvement allowances, etc.), which can be costly.
TIP: When pursuing a property below a Class A level, there are opportunities to raise its classification, i.e., renovations and adding amenities. These initiatives could attract higher quality tenants, increase rents and ultimately increase the property’s value.
Budget for Tenant Turnover
Probably more than any other asset class, understanding and planning for tenant turnover expenses for an office property can make or break projections. Unlike retail tenants who tend to stay in one location and not alter their size, office tenants move around more frequently. Their size and location requirements ebb and flow depending on what’s going on within their business. Consider the changes happening today due to the pandemic, such as social distancing and employees working remotely. While the extent of this is somewhat class-dependent, attracting new tenants often requires landlords to alter spaces to fit their needs or provide them with a tenant improvement allowance to modify the office themselves. Even when tenants decide to stay put and renew, they are typically still looking for landlords to provide them with funds to make improvements and freshen up their space. It’s typically cheaper for a landlord to make cosmetic changes than to replace tenants. When underwriting a new office investment, it is best to assume that tenant turnover will occur and plan accordingly.
TIP: Ask the Seller for a schedule showing the leases they’ve completed (new leases and renewals) and what was spent in terms of the work performed by the Landlord, a tenant improvement allowance, and concessions (i.e., free rent and rent discounts). Additionally, try and speak with the property leasing agent or a local leasing broker to determine the average leasing incentive package in that market. Don’t forget to account for downtime in your underwriting!
Look out for Gross Leases
Office leases are most commonly structured as a type of “gross lease.” In this structure, the Tenant pays a gross rental amount that includes their use of the space and other items such as their utilities, janitorial services, and repairs (even things like changing light bulbs). Unlike a tripe-net (NNN) lease where tenants bear the exposure to increasing property expenses, the Landlord bears the exposure under a gross lease because the gross rental amount stays the same regardless of whether fees increase or decrease. Some of these expenses are directly tied to occupancy levels (i.e., electricity or janitorial services in a tenant’s suite), so it is essential to account for these expense fluctuations.
TIP: Be sure to confirm all tenant lease structures and the responsibilities of each party. If the Landlord is responsible for utility costs, find out how the property is metered for utilities. Sometimes, adding submeters can help to transfer costs from the Landlord to the Tenant. Where possible, plan to try and convert to NNN leases.
Understand Building Systems and Prepare for Capital Work
Many office properties have common elements such as lobbies, bathrooms, elevators, exercise rooms, etc., that the Landlord must oversee. Understanding the age, condition, and potential repair and replacement costs of these elements and systems is vital to avoid significant surprises in an investor’s forecast. When an elevator goes down or the HVAC stops working in a tenant’s suite, the assumption is that the Landlord will repair these items immediately, and vendor service calls can add up quickly. Issues may arise more frequently when dealing with older or antiquated systems, and investors should underwrite accordingly. Bear in mind the expense of repairing or replacing these items and the potential risk and cost of not retaining tenants if systems are constantly in need of repair and tenants are unhappy.
TIP: Be sure to inventory the property’s common elements and systems to assess future repairs and capital expenses. Also, review the Seller’s actual costs to see what repair and maintenance items are recurring problems (i.e., roof leaks, elevator service calls, etc.). During the due diligence period, engaging trades to inventory systems can be done inexpensively and could help foresee any costly expenses. This information may also be used to negotiate a price reduction or credit if unknown capital expenses are discovered.
If you are considering investing in office property, please get in touch with us or send us a message by filling out the form below. The Innovative CPA Group provides services, solutions, and guidance based on our real-world experience in the commercial real estate industry.