Forecasting office vacancy - what would you do given this data?

Question

Considering acquisition of a class B office in Michigan. This would be my largest investment so I'm trying to be conservative in my models. The office is currently 5% vacant, but 25% vacant as recent as 3 months ago. I'm looking to make an offer based on a forecast of its average expected vacancy over a 10-15 year hold.  A prior thread on BiggerPockets suggested using a 20% vacancy rate for offices due to their volatility, but I'm having a hard time making that case to the broker based on the market data available. Sharing the data below and appreciate any advice on how you would forecast vacancy.

For reference: I plan to acquire for cash flow and maintain as needed; no active development.

Q3'16 Metro-Detroit Data; source: CBRE

Sub-Market data specific to the building in question (classes A,B,C); source: listing broker

(shows 8% vacancy)

Historic Vacancy & Forecast specific to the building's submarket; source: listing broker

I requested historic data dating back to 2005 to observe how vacancy was effected by the last recession, but historic data was only available to 2012. (chart shows: 15% vacancy in 2012, down to 8% currently)

I inquired how the aboveforecast was modeled, but no explanation was available. Can't say I trust it.

Unemployment: currently the lowest it's been since 2007.

Given: the property has 10 units and short leases expiring in 2017-2018. 3 tenants moved in 2016 (30%).  60% of tenants moved in since 2010. 80% of tenants moved in since 2005. For simplicity, assume all units are equal size, niceness, and cost.

Before receiving any data on the submarket (shared above), I initially used a 25% vacancy based on:

• 19.9% (20%) class B vacancy across Metro-Detroit currently
• increase 5% (to 25%) because unemployment is currently near record lows

I further expect unemployment to gradually trend up over 10-15 years due to automation & A.I.

25% vacancy won't fly with the broker or seller given the submarket data available, however, the submarket isn't the nicest of areas and isn't exactly up-and-coming. It sits 2-3 miles away from nice areas, and 2-3 miles away from un-nice areas.

Question: what vacancy would you find fair in making your offer?

Appreciate any advice.

Zach Quick · Answer

Someone needs to tag @Joel Owens. I guarantee he has more insight that hasn't been discussed here, even though he isn't a big fan of office.

Jeff B. · Answer

Can you predict the type of business these offices would be likely to draw?

If so, look for local competitors and get a feeling for their length of tenure and failure rates.

Eric Schleif · Answer

I would suggest contacting some local lenders or a commercial mortgage broker. They should know the area and market and can provide some insight on underwriting and what's available from a financing standpoint.

Just a few things I'm curious about from your post:

What's the buildings' total square footage? What's the average size of Class B buildings in the market? Any one single tenant lease a large amount of the space? Are the leases NNN? Also what's the average rent per square foot. Your CBRE chart puts the market at $16.72 PSF. How does your building compare? Do the leases have escalations? What's the average lease term for the market? These are the just some of the quick questions I try to answer on deals like this.

You point out the quick lease roll time, which is a concern. But this is the norm in certain markets. We are about to close an office deal in the northeast where all the leases are 3 - 5 years. That's just the norm for the local market and there are local lenders that will understand that.

Best of Luck.

Michael Anuzis · Answer

@Jd Martin, to clarify: the vacancy rate for this submarket declined from 25% in 2012 to 8% currently. (red line)

JD Martin · Answer

I don't think 20% is at all unreasonable based on the chart. For starters, my biggest concern is that your vacancy rate is trending dangerously upward. Granted, we are dealing with a very small sample size and what (on the surface of your chart) appears to be an unusual spike, but that may just be the foreboding of things to come. And you have otherwise good economic indicators but poor performance on this site? The area, or the complex, may have reached its apex and is now in a state of perpetual decline.