What kind of cap rates are you looking for?

Question

I'm currently working on development plans for two small office properties, one in Annapolis, MD and one in Washington, DC.

Cap rate on both , conservatively, would be approximately 7.2% ; that's at my sell point of 600K on each. If these are fully leased , new construction properties does this sound like something that will attract ample number of buyers?

I've got the tenants mostly lined up, one property already acquired the other under tentative agreement. Construction costs are well defined and unlikely to budge, I'm a commercial contractor and the GC on these and a significant amount of materials are already acquired.

I can always hold them both which I'm considering...just curious what cap rates I need to shoot for (which will affect my direction on interior finishes and  parking plans) to make them the shiny new things on the block that are coveted.

Roy N. · Answer

@Ray Browne

Those "tricks" are why many of us working towards energy efficiency see LEED as flawed - especially at the lower levels of compliance.   If is difficult to obtain a gold or platinum rating without at least a modest degree of attention to building envelop and energy recovery measures.

Account Closed · Answer

That's true.  10% is a good round number to start with as things always do deteriorate as the deal gets closer to completion.

David H. · Answer

Cap is largely driven by your tenant.  Find a good tenant (minimum 5 year lease) and you'll get a low Cap.  However, good tenants will shop, and you may have to lower the price to attract them.  Get lower quality tenants?  Well, your Cap rate goes up, but so does your rent, so what you do is you maximize for value taking both into consideration.

Given that you're talking about a small office, you're probably not renting to one of the big AAA rated corporations ready to sign a 5/10 lease.  Try to find someone like a professional (lobbyist, doctor, establish law firm).  Consider giving them a pre-lease discount up front in exchange for a market rate rent after the first month or two to entice them in.  Also, if you can get them to post up a 3 mo security deposit and/or sign personal guarantees, this can provide additional stability and certainty to the lease.

Getting lower quality tenants who might pay higher rent and providing a margin of safety with a higher security deposit is one of many ways you can lower risk for a potential buyer which increases value for you.

Matt Vaughn · Answer

We're building LEED Certified and LEED Silver for next to zero cost increase.  Gold and Platinum, in the buildings I've built, have had a cost delta, usually because of high-end strategies like geothermal and solar.  The success of the green building movement in recent years has had great affect on materials such that manufacturers are often selling as standard (no cost increase), products that help owners achieve their LEED goals.

If I were building my own building, I would invest in a LEED silver design.  I kid you not, in D.C., it wouldn't need to cost a penny extra (minus cost of the LEED certification itself) with an architect that knows what he's doing.  The reason I'd go for silver is that you'd get the PR benefit of LEED (which has real value), without increasing cost per square foot.

@Ray Browne, I apologize that this discussion somehow turned into a green building talk.  I wish I had a good cap rate for commerical, but I just have experience building them.  Let me know if I can ever help.

Joe Fairless · Answer

@Ray Browne - I always look for at least an 8 cap

Karen Margrave · Answer

I was reading an article a few weeks ago (I think on builderonline) that was about the houses in Louisianna that Brad Pitt was affiliated with after the hurricane. Anyway, they wanted to build them energy efficient, using sustainable materials, etc., and did. Now, come to find out the materials they used, though sustainable, don't hold up in the moist conditions, so the siding is falling apart. There's a huge lawsuit against the manufacturer that warrantied the materials for years, however; they are in China, so little that will be done.

I think offering "energy efficient" appliances, heating/air, good insulation, roofing, water efficient faucet, fixtures and landscaping, gets the job done as far as buyers are concerned, without us having to jump through the hoops for actual certification. Though people love voting for all the enviromental regulations, nobody likes paying for them.

I think when things go on the ballot, they should have to attach a cost per unit that it will cost each house, apartment, etc. and let people make an informed choice. Theory sounds good, but reality is always different!

Roy N. · Answer

Joel,

That about follows my read on the situation - though I like to distinguish between energy efficient and "green" as there are a lot of other elements in "green" certifications such as LEED or Passivhaus which deal with the sustainability of, and embodied energy in, materials.

Even in our residential properties where we have conducted a en energy efficiency retrofit and have demonstrated an efficiency improvement (of >70% in one instance, but usually between 40 & 60), we have not been able to command much of a premium to market rent, but we have noticed retention has improved (turnover is down).

All of our efficiency measures are undertaken with payback <10years ... typically 4-7, but some <3.   It is even cheaper to implement such measure when building new, which why I have difficulty understanding why builders would add the 8-15% to the construction cost in return for a lifetime of 20-30% lower operating costs.  I suppose that rarely is the builder the operator and if they are building spec they do not want to take the risk of the long sales cycle to education buyers on why their building costs 12% more to purchase.

Joel Owens · Answer

Hi Roy,

There are different levels of LEED certification compliance designations.

To get certain green credits you have to reach certain levels. The upfront cost of achieving these certs is very, very expensive. The tenants LIKE green features but in most cases they are not paying extra for it or will pay more just by a slight margin. They took a poll last year but I can't find it now where I found it and they interviewed tenants and asked them by how much more rent they would pay for a green building. The poll compared what the tenants would pay extra versus what a developer would actually have to cover in costs to rent to make it viable. There was a very wide gap between the two.

So for now what I see developers doing is not going for the certs as much but saying what could we incorporate with green features into a new build that tenants would see value in but that we could also save our money and recoup the costs in XX number of years??

The other issue is green buildings are so new they are harder to get insurance on as carriers do not have enough history to accurately asses risk yet versus standard buildings.

There are some green buildings but I am not seeing it on a mass scale yet. It's a cost versus benefit thing. It's like an electric or hybrid car sounds cool but after comparing how expensive it is versus a regular car the savings would take me too long to break even to see the benefit. Now if credits come in for buying such cars then it might could make it worthwhile.

It's the same with green buildings and also houses. People like to say they are helping the environment etc. and would like some green features but they do not  want to live to the extreme like the minority hard core do.

Roy N. · Answer

@Joel Owens

With apologies to @Ray Browne for introducing a slight tangent to his thread, I would be interesting in hearing about the weighting given to energy efficiency in your experience as a commercial broker.

Though efficiency is high priority for us, we find we are a minority and new builds are all being driven by the cheapest up-front capital costs with little thought given to the ongoing operational costs  - both for residential and commercial.   There are a few privately commissioned builds that have made efficiency at least a moderate priority, but in those instances, the owners were planning to occupy themselves.

The low quality of the commercial builds here, relative to the expectations of the seller, is one of the main reasons we've been to the alter three times in the past year with commercial properties.

Obviously tenants are not making it a priority, or the builders would be changing their dance.

Ray Browne · Answer

@Roy N. Just to clarify I'm with you on the LEED being useless at the lower levels..and I'm essentially a tree hugger without the tie die.

We use low VOC finishes as standard protocol on every project, we recycle almost all of our construction waste (stud cutoffs go to folks for wood stove heating, plywood scraps for shelving, paper products to recycling). I also use rainwater basins and every other program the jurisdiction has come up with for responsible guttering and storm water management along with minimal paving/clearing on every jobsite.

That being said if my project can qualify for the rating by using recycled sunflower seed plywood or I get credit for using that wax based or latex finish instead of lacquer I'm foolish not to take advantage of the opportunity and promote my building as such. Some of the requirements as far as facade go , one of the more onerous requirements I cited, are difficult as I'm in a historical area (though without the regulations) and don't want to rock the boat too much with a design that stands out.

What kind of cap rates are you looking for?

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