Your Thoughts on Investing in Office Space

24 Replies

The idea of owning office space right now is probably scary to many. I am wondering if there might be potential in smaller, more flexible office space, and I'd like to hear your thoughts. You know, the whole, "... be greedy when others are fearful...". idea.

I've invested in small multi for several years and am now looking for different options, particularly in the commercial space. I'm in a small market (60k people) with a large air force base that is getting a massive investment in the next decade that is expected to be huge for the local area. It's a capital city. Like most places, multi family is going crazy here.

I do not have tons of money or tons of investors, so I'm simply not ready to buy a big box store or huge commercial complex. I'd be using 1031 money.

There is an office building available in my small downtown area for what I believe is a fairly reasonable price (~$700k). It is mostly vacant. It's about 10,000 sq ft of office space, divided into about 20 individual suites (about 350-400 sq ft each). 3 floors, elevator and stairs, men/ women single bathrooms on each level, only street parking. Excellent downtown location, attractive building. Condition is good and needs minimal initial improvements (maybe freshen up the bathrooms). 3 out of 20 office suites are currently leased. I believe it would rent in the $10-$14 /sq ft range. My thoughts and questions, bearing in mind I am brand new to analyzing commercial deals:

- High vacancy, which is what I look for in multi family. Is there value add potential in buying vacant office space, leasing it, and selling at full occupancy?

-The layout is such that the offices could be occupied by single people needing a small office space or a company with several employees that could lease an entire floor. There are reception areas on each floor. This flexibility is what attracts me to this building.

- Am I delusional in thinking I can make money investing in office space right now?

Thank you for your insight!

Hey Jonathan, 

This actually sounds very interesting. However, you mentioned you don't have a ton of money or investors. I'm not sure about multifamily but in most commercial the banks look to the leases to determine how much they will loan you.  You won't be able to borrow a whole lot with only 20% occupancy. 

Will the seller carry a note? 

@Bennet Sebastian Great ideas and questions. I have a local bank that I use for all of my multi, so I have a good relationship with them. Hadn't thought about vacancy being a barrier because it's not an issue with them when I buy multi family. But it could be an issue with office space. I will certainly inquire about seller financing! 

@Jonathan Hayek

I think you have the right idea. I own one building very similar to what you mention and under contract for another. One important thing to identify is how they got to 700k price tag. Commercial prices are directly tied to the income it produces.

Only 2 tenants may not be enough to cover your expenses for a building that size.

Let me know if you have more questions. Happy to help.

My LLC holds a two story, Class B suburban office asset that is 7500 sq feet in a growing area (upstate of SC), and it actually held firm during the worst of the lockdowns last year due to COVID-19. The building is fully occupied with five separate tenants, ranging from a solo employed tenant to a larger 6-employee business.

I would evaluate the demand in that area to see how long vacancies take to fill.  If those local vacancies have persisted due to a high number of office spaces for lease, I would certainly be cautious as you may have to carry that note for a while (and assuming you can get a purchase price that makes sense).  Also, if the area is undergoing growth, that could certainly be a factor to consider as massive growth at military bases can also portend third party contractors/companies that will support that base’s mission.  But are there other economic drivers locally?

@Jonathan Hayek As @Jeff Stein noted, in Commercial property, price is more so a direct reflection on occupancy, strength of leases, and therefore the NOI of the property. In this case, a mostly empty building will not generally carry as high of a premium in price, since you as the buyer would then have to put in the foot-work to value-add, build-out, and lease up the property. In the mean time, a building like that will burn cash fast, so if your reserves are not sufficient, that could prove detrimental. Things like property taxes, ground maintenance, elevator licenses and maintenance, HVAC (this is significant if the current leases are NNN vs. Gross and if there are "base years" in them. A whole other discussion can be made on that...) will all be constant costs regardless of tenancy. There are benefits to buying a blank slate however, just like in Residential when you can hand pick your tenants. In this case, you can structure great leases, easily make improvements and value-add before marketing the spaces, and turn the property into a nice cash-producing asset. If the area will be growing with the military base, then now would be the time to position yourself with such an asset and be ready for when all the supporting infrastructure starts moving in. But again, it comes down to cash reserves to stay afloat until that happens.

@Jeff Stein @Will Kenner @Jade S.

Thank you all for the helpful and insightful comments. I went for a second look yesterday with my agent and the listing broker, who is also the seller and got some more information. My agent is very knowledgable about the commercial space and I have a great deal of trust in him. He described the building as B- quality with very few A quality properties in town. The location is top notch. 

The building was fully occupied pre-covid with a single tenant but that tenant vacated. The seller has put a few single tenants in there now, and it's probably 10% occupied. It seems like the seller is hoping to get an owner occupant cash buyer. Both the seller and my agent voiced the same concerns as you all about getting financing on a mostly vacant building and me only having experience in multi family and none in the commercial space. I do have a few investors that have lent to me in the past. The seller has a loan but is also willing to carry part of the purchase. I'd estimate she owes something in the $380-$400k range. It was purchased 6 years ago for $540k. 

My agent believes they came to a list price by square footage. The seller had basically no financial info at the showing, so we've requested it. Thanks for the tip about the elevator costs. 

Most likely, this building will end up being filled with gross leases. With multiple tenants, I'm told it would just be too complicated to do anything else. 

My agent said expect it to take 12-18 months (conservatively) to fully occupy the building. It is taking longer to lease really large spaces but spaces in the 500-2500 sq ft range (like this space) is tending to get leased more quickly. 

I totally understand the NOI driving the value of the property. The vacancy is why it hasn't sold and why I see opportunity in it. It's a deal that experienced investors probably wouldn't mess with but could be a learning experience for me. Having plenty of cash reserves would definitely be a priority, knowing it could be 18 months before it cash flows.

As for the market, it's across the street from the county government complex and a few blocks from the state capitol complex. The military base improvements are expected to be a huge driver for the town. Not many large employers in town. It's a small town but is growing. 

@Jonathan Hayek Good for you for thinking outside the box! I totally agree with the Warren Buffett quote and its application here. I'm looking into a commercial space right now in OKC as well, which is definitely not what I have been focusing on, however I see some solid value and potential in the smaller, B+ commercial spaces right now. My broker mentioned the possibility of breaking the space up into much smaller offices and renting those out individually if necessary to limit vacancy. That may be an option for you as well.

Have you already talked to a lender about this deal? I'm curious if the pre-approval process is similar to purchasing residential properties in an LLC.

@Douglas Spence Yes, leasing the space to several smaller tenants is probably the way forward for many office spaces. I think it'll be unlikely in my market to find a single tenant for 10,000 sq ft of space in a reasonable amount of time. 

I am waiting to talk to my lender until I get full financials from the seller. There is a chance my local lender here will lend on it. They funded my first deal ever when nobody else would and have taken chances on me. I think I've returned the favor of being a good borrower for them and have built my reputation. This lender will lend to an LLC, so no issue there. I am also considering ways to bypass the bank by raising funds along with some seller financing.

I think there is tremendous risk in a mostly vacant office. Why not dip your toe into a mostly occupied building first? Gross leases are terrible to manage and impossible to exit. Buyers of office are expecting NNN.

You mention its "single Tenant" in commercial that means one tenant for the entire building/parcel. Not multiple single tenants. Just useful for clarification. Is it 10% or 20% occupied? You need to see a rent roll, but this can easily burn a lot of cash.

@Ronald Rohde Great points, thank you. I cannot afford mostly occupied buildings. That's why I'm looking at mostly vacant and adding value by placing tenants. There are some motivated sellers, some offering seller financing. Thanks for the tip about buildings with gross leases being difficult to sell. Definitely a factor. 

Originally posted by @Jonathan Hayek :

@Ronald Rohde Great points, thank you. I cannot afford mostly occupied buildings. That's why I'm looking at mostly vacant and adding value by placing tenants. There are some motivated sellers, some offering seller financing. Thanks for the tip about buildings with gross leases being difficult to sell. Definitely a factor. 

 Can you find smaller buildings with lower price points or higher cap rates? Those tenants will require more work to replace and generally shorter lease terms.

Originally posted by @Jonathan Hayek :

@Ronald Rohde It might be possible. But where's the value add there? At my point in my career, I'm not interested in buying a 6 cap and just sitting on it. I need to add value to build wealth faster. 

 The value add is in increasing occupancy from 50-90%. Taking a building with ZERO cash flow is very risky, you're losing money every month, vs covering your debt and expenses while still being able to force appreciation to build "wealth." YMMV, just pointing out the way I view the risk/rewards here.

@Ronald Rohde Makes complete sense. 

What do you think of this: I looked at another vacant commercial property that could be a candidate for a NNN lease. Seller wants to finance it. My agent said to make an offer contingent on finding a tenant. So, get under contract, look for a tenant, then execute contract once a lease has been signed. Seems low risk to me if the seller agrees. I'm told the building has been vacant for years because the seller has lots of properties and just doesn't care much about this one.

WAY too much risk for me personally 
with so many great ways to make money I personally would never do it 

I ma very interested to hear back in a year how it goes 

@Jonathan Hayek I like your second scenario better than the first. Still a bit of risk but also could be an opportunity if done well and you have the ability to carry it until you get a tenant. You may also have to invest in some tenant finish to get it done. Remember, that if you plan to hold this for at least 3 years, you will want to seriously consider a cost segregation study to reduce or eliminate your federal plus state taxes for a while by accelerating the depreciation. This would give you an additonal 6-10% of your purchase price in after-tax cash flow in the first year. 

I closed on some office space today. I was able to basically buy it at a 40% discount to what it would have sold for 2 years ago.

SFH residential is as hot as it has ever been. Ive been pivoting to the cold assets. Condos in the city and office space.

I work for a fortune 200 company that is very conservative when it comes to employee issues. They only started letting people wear jeans to work about 3 years ago. When the pandemic hit, the first thing my company did is try to cancel lease contracts. As with any corporation, we have a team of lawyers that descended on the landlords. With my companies main office, they had just signed a 5 year lease. They negotiated with the landlord to completely remodel the entire building at his expense in exchange for honoring our lease. The renovation is removing all offices. Even executives will not have offices. They are reconfiguring it to open concept, where you will reserve an office or meeting room, when you need one. Work from home is the expected norm, so people will only be in the office a couple days a week. This is allowing my company to condense twice the people in the same space. My wife's company is even more conservative. She works for a bank and guys still have to wear ties to work. They are hiring in customer service and all the positions are work from home. They test your internet speed at home as part of the application process. Countless companies have announced flexible work from anywhere policies. 

There will still be a need for office space, but we are only seeing the early stages of price effects. I believe it will crash as demand drops further, leases expire and businesses adopt "work from home" policies to retain employees. My concern would be that the building is vacant. If your city has demand, why haven't they leased the space? If you do pursue the deal, get a deal and set aside cash to carry the vacancy. Also consider options for converting the space to an alternate use. Maybe retail on the first floor or multifamily on the upper levels. 

Be greedy when others are fearful, only applies if there is a brighter future for the asset class. 

@Bonnie Griffin Kaake Great ideas. Thank you. 

@Russell Brazil Tell me more about your deal. What's going to be your strategy with it? 

@Joe Splitrock Fantastic insight. I am very detached from how large companies are pivoting right now, so any info in that area is much appreciated. I assume most companies are moving more towards work from home, but will still need some office space. This is why I'm looking at smaller spaces. I wouldn't consider buying 100,000 sq ft for those reasons. But it seems like there could be opportunity with 10,000 sq ft or less for the types of situations you explained. I've also considered splitting spaces into more of a co-working space setup. 

I totally get that there is risk in this asset class right now. However, in five years, what are we going to be looking back on saying, "I wish I would have bought more of that!"? Multi family? Probably, but it's so hard to find a decent deal in multi. Offices can't just vanish so I'm trying to gather as much info as possible to get into areas where others are not right now. 

@Jonathan Hayek I have successfully rented out a small office building since COVID.  But, they are even smaller than you mention.  My building holds 8 office suites, ranging from 150-750 s.f. each.  The offices hold 1-8 people each and all of them have private restrooms.

A few value add ideas; add private restrooms, private mini-break rooms, and private building entrances.  Anything that will limit contact between as many tenants as possible.

The feedback I've gotten from my tenants is that they love that they can shut their team's office suite door and never come in contact with anyone else during the course of the day.  Nobody ever leaves their door open.

@Rebecca Calbert Sounds like a really unique property! If I had it, I'd be tempted to turn it into multifamily! I'm curious what market the property is in? I ask because of the regional differences in COVID hysteria. I could be wrong, but I don't know that some of those value adds would be valued as much in my market. It would certainly be nice to have private restrooms and break rooms for every office but that's also lost space that could otherwise be generating income. 

I would do some more market research first.  Local vacancy rate?  And what has it done the last year or so?  And then, if possible, how much sublease inventory is out there?  And average time on market?  What is stuff actually leasing for?  Any new supply coming online in the next two years?  Broker should be able to pull together a couple CoStar reports that detail all of this.  Also, office usually takes at least some capex to get ready for turnkey occupancy.  What worked for the last tenant usually does not carry over.  So be really conservative on what your psf buildout number is going to be.  Small offices like this that's almost all going to be on the landlord's nickel.  BTW, that is the usual complaint I hear from office landlords, that its capex/opex heavy relative to the risk-adjusted returns (at least compared to other asset classes).  12-18 months to get to stabilization?  That's a long time and will require a big reserve upfront.  How long to get to breakeven occupancy?  Can you use some of the space for your own business needs?  That might alter the economics (and lender appetite) somewhat.

Also, the listing broker owns the building and it has that kind of vacancy?  So this isn't a mismanagement situation in all likelihood (which is where the real value-add magic usually happens).  If an active broker can't fill it . . . 

Now, the good thing is that the macro numbers seem to indicate we are in for some serious job growth over the next few years.  And job growth usually drives office leasing fundamentals in a normal growing economy.  Assuming we come out of COVID vaccinations with most people reasonably willing to get back together in offices in some form or another, demand should come back.  So the long term play here might be pretty interesting if you can find patient capital.  But it would be a long-term hold given the front end expenses of turning around a property like this.  

@Andrew Tripp Great thoughts - thank you. Basically, I'm told there is a "glut" of office space available right now and I should be prepared for it to take 12 months to fill. So having big reserves will be important. Market rate for B class office space is $15-16/ ft. 

This other building is perhaps more intriguing to me. Could be a single tenant NNN. It would take about $30k to modernize bathrooms, replace carpet, and update lighting. My angle would be to offer a few months of free rent, one year below market rent ($12/ ft) and then gradually step it up market rate ($16/ ft). It would be a huge risk, but a huge reward. Purchase at $650k vacant, get a NNN lease, and sell in 3-5 years for $1.2m+. The issue is how long it would take to get a tenant. Who knows.

I like the contrarian investment strategy. However, I would really look at how long it could take to lease up, absorption rates, office demand with WFH still going strong, etc. I would also look at conversion to medical office space as a possible option. This sub sector has been performing somewhat well during these times. These turn around deals usually take deep pockets and a strong stomach. I work for a local lender and we have financed similar deals. We would usually require you to master lease or set up adequate reserves until leases are signed. 

The second deal looks promising. I'd reach out to some retail leasing brokers and ask about the viability of landing a NNN tenant for that space. They usually have their own requirements, traffic counts, income demographics, etc...