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Office Space 101

If you’re thinking about purchasing commercial real estate as an investment, office buildings can be an exciting prospect. Potential investments range from small single tenant buildings to the downtown high-rises that define a city’s skyline. For those new to the arena, it can be a complicated endeavor full of strange new terms. With some research and a little perseverance, however, you’ll soon find yourself fluent in the language of office real estate and ready to make your first deal.

Know Your ABC’s

Office buildings are categorized in three different groups: Class A, B and C.

Buildings are given a Class A designation if the design and finish are of the highest quality, they attract quality tenants and are professionally managed. Class A buildings have superior locations and command rents at the top of the market. Think of the new glass and marble building in a financial district, occupied by lawyers, stock brokers and other high end tenants all desiring the trappings of success — that is a Class A building.

Class B buildings have rental rates considerably lower than Class A buildings. While they are well maintained and have a good quality design and finish, Class B buildings may be located in less expensive office parks or suburban areas. Class B buildings are often older Class A buildings.

Class C buildings tend to be more utilitarian than aesthetic. They are often more than 20 years old, but still have steady occupancy. Many are located in mixed use buildings, often on the upper floors above retail or service businesses, or in industrial parks. Class C space rents for less than Class B space, typically in the lower 20 percent of a given market.

It is important to note, however, that while these buildings need to meet more than one requirement to be categorized within a building class, there is no specific formula and there may be a judgment call required in a final analysis.

Valuation and Cash Flow

Office buildings are valued to a great degree as a function of their income - ultimately the tenancies and leases that are in place - while residential real estate is not. A residential duplex or single family home is typically appraised at or close to the same value whether it is vacant or tenanted. This is not the case for office buildings. A fully tenanted building boasting long-term leases and national tenants will be valued considerably higher in the market place than an empty one. Commercial appraisals use a combination of three methodologies to value a building: the cost approach, the sales approach and the income approach.

With the cost approach, appraisers calculate how much it would cost to rebuild the structure from scratch, including the purchase of the underlying land. Appraisers typically assign more weight to this approach for buildings less than five years old or if they are highly specialized, such as medical offices.

The second method is the sales approach. This is analogous to the “comps” that realtors use when setting residential home prices. Appraisers conduct extensive research, looking at similar buildings in the market and comparing square footage, location and a host of other factors before calculating an estimated sales price that could be achieved for the subject property if it was listed for sale.

The third approach, and perhaps the most useful method for office investors conducting due diligence, is the income approach. This value is based on the net income a building owner makes on the spaces that are leased (you will also be able to estimate your cash flow with this model as well). The appraiser takes monthly rent payments from the rent roll (a document listing all of tenants and information about their leases) adds them together and calculates the buildings gross income. Net operating income (NOI) is then determined by subtracting the expenses from the gross income. With that information in hand, it is back to the market to research what capitalization rates are for similar buildings. A capitalization rate, or “cap rate”, is a ratio of net income and capital cost. It is calculated by taking the NOI for the building and dividing by the purchase price. For example, a building purchased for $1 million that generates $100,000 in net operating income has a cap rate of 10 percent.

$100,000 / $1 million = 10% cap rate

When valuing properties it is useful to think of the cap rate the same way you would look at a rate of return for any other investment. The higher the cap rate, the higher the rate of return on the investment, but also the higher the perceived risk. Cap rates vary depending on the location, size and history of the property and will be lower for Class A buildings than it will be for more risky Class C ones. Once a cap rate is determined, it is divided by the NOI to determine the value of the property. For example, a Class A building at a 7 percent cap rate with $140,000 NOI will be valued at $2 million dollars.

$140,000 / 7% = $2 million

A commercial appraisal will typically calculate a value using each approach, and then combine all three, weighing each to fit the specific building and market being evaluated.

Financing

Generally, commercial loans have a set of underwriting standards that are fundamentally different from residential ones. Basic criteria such as personal credit history and loan-to-value are still relevant, but there are other factors that come into play as well. Where residential loans require that you pay back the loan with personal income, commercial loans are repaid through the cash flow of the property. Lenders will look at the amount of cash available to repay the debt after you’ve paid all of your operating expenses. Many banks will have a set income to debt ratio, called debt service coverage ratio (DSCR) that you will be required to maintain during the life of the loan. A DSCR of 1.0 means for every dollar of net income there is a dollar of debt repayment. Expect most lending institutions to require a DSCR of at least 1.25 — one dollar and twenty five cents net income for each dollar of debt repayment — before they consider a loan viable. Lenders do this to ensure there is enough money to cover unforeseen or emergency expenses that arise over and above the regular loan payment. In addition, commercial loans usually have higher interest rates and require a larger down payment.

Leases

There are numerous types of leases for renting office space, the three most common being the gross lease, modified gross lease and triple net lease. Gross leases usually benefit the lessee the most. The renter only has to pay rent, while the owner of the property is responsible for paying all other expenses such as utilities, repairs, insurance and taxes. A triple net lease is the opposite of the gross lease, where all burdens of taxes, utilities, maintenance and rent are the responsibility of the tenant. A modified gross lease is between the two – the tenant and the property owner share some of the costs (such as the tenant paying rent, utilities and taxes while the owner is responsible for building maintenance and upkeep).

While a triple net lease can often look to be the most attractive option for a landlord because of the cash flow, they can sometimes be risky. A renter who enters into a triple net lease may not be able to cover all of the expenses associated with the property, or will allow the building or property to fall into disrepair (in extreme cases, tenants have been known to intentionally damage a building to collect the insurance). However, most triple net leases contain provisions that protect both the landlord and the tenant, such as requiring tenants to pay into a reserve fund so that expenses can be paid in case an unforeseen emergency arises. Also, in some instances, there may be a cap on the amount of property taxes the tenant is required to pay, leaving the rest to be paid by the landlord. The most important thing to remember is to make sure all the terms of the lease are clear, fair and understood by both parties.

As a part of your due diligence, and certainly prior to closing, you will want to have all current tenants sign estoppel certificates. Estoppel certificates are simply an acknowledgement by the tenants that the lease they signed is still in full force and there are no existing issues that would cause either side to claim otherwise. It might sound like overkill, but it could be financially devastating to purchase a building only to find out that the biggest tenant is in the process of moving out because the previous landlord failed to fix the air conditioning.

Management

Unlike residential property, managing commercial office buildings can be a full-time job. Except in the case of smaller properties, it will most likely be advantageous to hire a property management company to lease, maintain and manage your buildings. There are a number of excellent firms that provide this service. They employ professionals that have their finger on the pulse of your market. This is particularly valuable when looking for new tenants as most savvy commercial property managers will have buildings full of tenants who are often looking to up or downsize. The fees are reasonable, usually running somewhere around 10 percent of gross rents for property management, with new leases done on a commissioned basis. If you are a serious investor who wants to spend your time vetting new projects, you should seriously consider having someone else take care of broken toilets, meeting tenants and negotiating leases on a day to day basis.

Investing in office buildings is a professional undertaking which requires long term commitment. It is, however, a rewarding one that can provide a constant source of income and opportunity for years to come. Like all investing, it is a balance of risk, work and reward so if you’re ready to take on a bigger challenge and move to the next level of real estate investing, then an office building might be in your future.

Office Space Investing

There’s one real estate veteran out there who has enjoyed quite a bit of success over the years in virtually every kind of market imaginable, and he has a knack for condensing years of experience into easily digestible sound bites. Those who are looking to invest in commercial properties that can be used for office space or small businesses will likely find little fault with some of this fellow’s latest nuggets. For example:

• Make sure you create sizzle, glamour and prestige with whatever property you’re investing in;
• Accept guidance from only the best real estate and investment specialists you can find;
• Give your potential tenants the best perceived value imaginable for whatever it is they’ll be renting.

True enough. Who can argue with that? The properties in which you are interested should flash dollar signs not only in your eyes as the investor, but also in the eyes of those who will eventually occupy those spaces. Furthermore, the professionals you are working with to make it all happen should know how to avoid any pitfalls that sneak up along the way. Only then will you come out of the experience with a newfound respect for tycoons like the one who offered those little sound bites in the first place.

His name happens to be Donald Trump.

The problem is, of course, that by definition, sound bites do not go into details, and much of real estate is in the details, from investments analyses and downtown renewals, to security deposits and tax implications — and a thousand other variables in between that can and will affect any venture into the business. (In Mr. Trump’s defense—not that he needs defending—he has authored several books on the subject that flesh out many of those details.)

Nothing Ventured, Nothing Gained

Very few brokers, lenders and other professionals involved in real estate will recommend that new investors start out in the commercial end, even if it’s for a modest undertaking like a small office building. There are several reasons for that, many having to do with vacancy and rental rates in that particular market, which tend to be somewhat erratic. On the other hand, many veterans and observers will eagerly repeat that old chestnut: nothing ventured, nothing gained.

“People are indeed purchasing commercial office space as an investment, but not nearly as much as other asset classes, such as multifamily properties and strip centers,” said Michael Brewer, vice president of Carteret Commercial Mortgage, a nationwide firm headquartered in Fredericksburg, VA. “Typically, the down payment requirements for these types of investments start at 20 percent and go up, depending on the quality of the deal.”

While any real estate investment has challenges that range from the up-front financials to the back-end returns, the office space and small business market sometimes falls into gray areas in which the experiences of others may bear little resemblance to the experiences that are in store for you.

“More people used to do this, but less nowadays because property values make it difficult to make business sense of an acquisition,” concurred Joseph De Sane, vice president of the Bridgehampton, NY, office of The Corcoran Group, a major real estate firm with branches throughout Long Island, Manhattan and in South Florida. “Those who want to give it a try, particularly for the first time, should work out a business plan that is capable of a 10 percent return on the investment per year—at the very least.”

It’s certainly possible - but not always.

The Attraction

Still, there are several attractions for both the newcomer and the old-timer to go into commercial real estate. For one thing, in the right market the rents can be lucrative. Also, in the commercial world tenants tend to be somewhat more responsible for the maintenance of their rented spaces than many residential tenants.
But perhaps one of the biggest inducements is the fact that you can use some of the new space for your very own — such as a small office that can accommodate your growing real estate investment business. (Many an empire has begun modestly that way.)

Fortunately, commercial real estate often presents opportunities to do much more accurate analyses of the market than other kinds of investments, and that can help determine whether or not it is a good time to get into it. Unfortunately, the Newtonian-like laws of real estate dictate that for every potential draw there is a potential snag. But with eyes wide open and a skilled support team just a cell phone call away, many of those snags can be avoided. You just have to be prepared for them.
First of all, commercial real estate is always more difficult to finance. It often takes more time than many people are willing to spend to find suitable tenants, which means that you will have to pay taxes and insurance until the space is occupied.

Secondly, when tenants move out, new tenants very frequently require changes, customizations and improvements that can be costly — and as the owner you may wish to agree to cover those expenses (even if you’re not legally obligated to ) just for the luxury of staying competitive.
Pitfalls can also occur when an investor does not put in a long enough review or settlement period into the contract. In commercial real estate, patience is as important as security.

“The ability to think ahead is also a virtue,” added De Sane. “Imagine how frustrated you’d be if you go through all the twists and turns of buying a property for commercial office space only to find out at the last minute that it is not zoned for that use.”
In other words, do your homework first.

Commercial Space Growing

Despite challenges, setbacks and the occasional nightmare, the market seems encouraging; apparently enough people are doing their homework first because there are many indications that office space investment may be one of the hotter markets in the months and years to come.

“The office sector will clock substantial expansion in 2006 where vacancy levels are expected to decrease while rents are poised to increase,” said Ross Moore, senior vice president of Colliers International, the global real estate services firm based in Boston, which recently conducted its annual Commercial Real Estate Forecast.
Similarly, the National Association of Realtors (NAR), in its own Commercial Real Estate Outlook, concluded that the need for office space seems high by virtue of the fact that vacancy rates are expected to drop to an average of 12.7 percent in the fourth quarter of 2006 (down from 13.6 percent during the same period last year). At the same time, office rents will rise 4.4 percent.

“Commercial real estate remains a bright spot in the economy, but there are concerns over energy costs, rising interest rates and slower-than-expected job growth, which could dampen future demand,” explained NAR’s David Lereah, chief economist. “With tightening vacancies and a slowdown in speculative construction, the office market will offer respectable returns for investors.”

According to the NAR, areas with the lowest office vacancy rate today include Ventura County, CA; New York City; Orange County, CA; Fort Lauderdale; Riverside, CA; and Washington, D.C. The top markets for office investment over the last year were Manhattan, Chicago, Los Angeles, San Francisco, Northern Virginia and Washington, D.C.

But a national study like that cannot possibly take into account the trends, benefits and liabilities of investing in commercial office space in smaller towns and villages all over the county. Indeed, almost every fairly active Main Street commercial district has a property or two in which an investor may be interested to look for office space or small business properties. In fact, some experts recommend finding out where ‘downtown revitalizations’ are taking place. The existence of Special Improvement Districts, or SIDs, is often a key indicator. These areas are frequently prime suspects for office space investment; sometimes it comes with the opportunity to invest in a building that has offices upstairs and retail space for small shops and services on street level. As far as office space is concerned, the proximity of shops, services, restaurants, parks and other municipal attractions can provide at least some of the sizzle, glamour and value that Mr. Trump was talking about.

“If I were to get into this area of the market right now, I’d definitely look for areas where there are signs of future commercial activity — such as new housing developments going up where once there were nothing but farms and fields,” said Brent Zimmerman, a broker with the Prudential Group in Southern California and an individual investor who carefully monitors all the trends. “Obviously, commercial development, including the need for office space, is going to follow residential development. Many new residents are going to be looking to start their own businesses or open their own practices of one kind or another.”

One way to learn about commercial and office space investment is to note how it may differ from residential, industrial or speculative investments. Much of the distinction goes to the kinds of lease agreements you will use with your tenants.

Primarily, you will rent your office space for a specific dollar amount per square foot of space. The leases you use will often resemble loan documents rather than rental agreements. (Lenders often rely on these documents to collateralize loans.) You might use a net lease with which tenants pay a portion of the building’s maintenance. If residential investing is the only real estate activity in which you’ve been involved, you may very well learn about entirely new kinds of leases as you go forward, such as triple net leases (where the tenant pays for maintenance, insurance and property taxes), or gross leases, where the owner is responsible for energy cost increases. Office building leases can also be simple month to month rentals.

Do Your Homework

Without a doubt, advice is plentiful but it never takes the place of personalized research geared to the specific city, town or village in which you’re interested. Partnering with knowledgeable real estate professionals, mortgage brokers and investment counselors is also important, as is listening to the stories of those who have already been there and done that. Some of the stories are priceless. Like the one about the owner of a two-story office building in New Jersey who rented out space to a holistic health company only to discover (after the police raided the place) that it was actually used as an illegal massage parlor.

It’s worth repeating: do your homework first.

Obviously, questions must be asked, research conducted, situations assessed and tools acquired before any commercial or office space investment can be transacted.

For example, before signing on the dotted line ask yourself:

• Is there ample parking for my tenants’ needs?
• Is this a safe community?
• Is this building structurally sound?
• What are the local laws and ordinances concerning handicap parking and accessibility, and how does this building fit those requirements?
• Did I analyze the property and all related documents well enough?
• Did I check to see if there are any hidden costs with the brokers, agents or consultants with whom I am working?
• With regard to my loan, am I getting the best type for my needs? (There are several kinds of loans, including SBA 504 loans, adjustable commercial mortgage loans, hard money loans, sale-leaseback agreements and more; all have different terms, gains and risks.)
• Did I request the business financials of the tenants I already have lined up to take possession of my office space so that I can be assured of solvent tenants? (This can help avoid having tenants who, in turn, invite nervous-looking men to go in and out of their office at regular intervals.)

If you are new to the market, the region or to investing in general and want to take a good look around before you leap, you should:

• Stay in touch with local business community, chambers of commerce, city councils and planning boards to find out the local trends, needs, ordinances and potential investment hazards.
• Avoid areas where the supply of available space has increased faster than the demand for it, or where vacancies occur frequently and rental rates fall quickly. (This is called negative absorption.)
• Become accustomed to leaving plenty of time for all the proper appraisals and inspections to be conducted. As frustrated as investors often are in purchasing homes, commercial investors can be equally or even more frustrated at some of the methods and madness associated with commercial real estate.

No one ever said it was easy. Not even Donald Trump. But it can certainly be accomplished, and the results can be advantageous. To be sure, the benefits are not necessarily just financial gain for you, but economic gain for the community at large. Prime, attractive, useful, relatively affordable office space can help provide business opportunities (and jobs) for many people. That, in turn, brings in more revenue to the town, which can translate into municipal improvements and a better quality of life for everyone. That’s the kind of thing that can provide enough personal sizzle to make you feel like a real VIP — even if you haven’t written your own book yet.