A real estate investor needs to be both a good analyst and a great capital raiser. KISS guides are meant to help you solve one of those two needs: a better analyst.
Keep It Simple Stupid guides are meant to provide investors a framework for understanding the supply-demand indicators and valuation techniques within each major commercial asset class. Last time, we discussed KISS guide to Multifamily Assets; this week we discuss Office Assets.
The Basics of Investing in Office Buildings
The “office building asset class” is composed of buildings with high, mid or low-rise structures that account for roughly 20% of the total commercial real estate market. The office asset class presents unique set of challenges given that historically it has been the most volatile sector relative to other real estate asset classes. Office investments are a low Sharp Ratio investment class, driven by a high volatility due to a combination of macroeconomic, supply and demand and property specific factors.
Hence it is vitally important that before making your first office investment, an investor work through the investment analysis framework. The funnel starts with the Market Analysis and works its way down to the Investment Analysis.
Market Supply-Demand Analysis
Office assets are driven by a complex mixture of macroeconomic and supply-demand trends. The key indicators for each force (supply or demand) to keep in mind are as follows:
Growth (Demand) Indicators
- White Collar Job Growth: projected job growth as indicated by the Bureau of Labor statistics survey can be a great leading indicator for office space demand growth by space users.
- Economic Growth: increase in the overall economy or regional economy increases the likelihood that business will hire more workers on a full time basis and, in turn, will require more space for these additional workers. This can be tracked by a Gross State Product found through the Bureau of Economic analysis website.
Headwind (Supply) Indicators
- Vacancy Rate: This rate is an inverse indicator, as rising vacancy rate will lead to a decline in the rent per square feet along with increased turnover at a building.
- Absorption Rate: This is the amount of newly created space that is leased in a given market during a period of time. If the absorption rates are rising it means that rent prices should be rising in the near term dependent on overall vacancy rate.
- Nearby market supply: The substitution effect of nearby supply for Class B and C building can keep rent price growth in check even though vacancy rate is declining, and absorption rate is rising.
Market analysis should be completed at both the regional and local level to better understand the position of an investment relative to the marco (regional analysis) and the micro (local analysis) trends.
As you work your way through the market analysis framework and start looking at potential investments, office properties are often designed and marketed to a particular type of tenant base:
- Specialized Tenants: building that focus on a particular use i.e. R&D hence these building are meant for specialized tenant base.
- Agonistic Tenants: a standard building in a suburban setting attracts a broader range of tenants.
- Niche Renters: A building designed for a particular business type. For example, a building close to a hospital would target medical practices and labs and therefore the building should have the features that fit the space needs of the niche tenants.
Understanding the needs of the space user group will help define if the investment is product-market fit in terms of matching the current and prospective future needs of the space users.
Office Building Structures
Assets typically have a vertical layout (high-rise, mid-rise, low rise). It is important to judge the structure for both adequacy of total square footage and square footage per floor plate. What do I mean by the second square footage per floor plate? It is something that initially escapes an investor at first brush but makes sense once it is explained.
Square footage per floor plate is important, because if the floor area is too large, the distance from light sources and the building core will be too great and thus will diminish the overall appeal of the internal spaces. However, if the floor area is too small then the space usually cannot be adequately utilized.
The Different Classes
Just as in multifamily/apartments, office assets are typically assigned quality rating (Class A, B or C) depending on the property characteristics and local market definition of class levels. The quality ratings are far from universal as they vary depending on local market standards. Below is an attempt to generalize each class:
- Class A – The most attractive asset class to both investors and tenants alike given that the building is located in a high visibility or “status” address area and is characterize by high quality of design and amenities. These assets are considered a core asset given the condition, location and high class of tenants. These assets work well for core strategy oriented investors i.e. pension funds, core focused REIT/funds or any investor seeking low standard deviation oriented investments.
- Class B – The buildings are usually older but functional with less appealing design elements. Rents will tend to be lower than Class A buildings and the mix of tenants will typically be of lower credit quality. These assets are considered value add and work well for gamma strategy oriented value add investors i.e. private equity groups, turn around investors, higher return seeking family offices.
- Class C – The oldest of the building in the least desirable location. These assets typically have sub-standard tenants, cosmetic and functional obsolescence. These assets are considered a turn around and work well for opportunistic investors who are seeking to complete alpha strategies of improving the class from C to B to help gain equity value growth.
Office Building Valuations
Office assets are valued using a multiyear discount cash flow analysis model that is made up of the following building blocks:
- Gross Area – The physical area of all the floor space in a building.
- Rentable Area – This area is generally calculated as the Gross Floor Area less area of vertical protrusions (stair wells, mechanical shafts) plus an allocation of the common area directly benefiting the tenant i.e. bathrooms, common corridors, and elevator lobby on the tenant floor. This is the area on which the rent is charged which is usually greater than the useable area
- Useable Area – The area that is within the tenant rental space/box.
- Gross Rents – Gross Rent is calculated as Total Rent per Square Foot including basic rent of the space, proportional coverage of taxes/utilities/insurance over a base year times the Rentable Area.
- Reimbursements – Depending on the type of lease (Modified Gross, N, NNN) a tenant can be responsible for paying back the landlord as additional expense increase above a base year (usually the year in which the lease is fully executed) or a proportional share of all building operating expenses (if the tenant lease is a NNN).
- Vacancy – A projected period of time that rent will not be collected due to collection issues and/or tenant eviction issues. This number is driven by local market and the class your building is considered i.e. Class A, B or C.
- Turnover – In addition to vacancy rate, a turnover assumption is needed to model out how many expiring leases will renew or will go back on the rental block. The turnover assumption drives the following two sub-building blocks:
- A. Lease Commissions: The renewal or non-renewal of a tenant will impact the exact amount of money paid out in any fiscal/calendar year to the leasing broker
- B. TI aka Tenant Improvements: An allowance that the owner will provide to the tenant for customizing and preparing the tenant space at the time of lease or release.
- Operating Expenses – Property expenses associated with operating the asset that is paid by the owner. In office buildings the typical operating expenses include repairs, security, snow removal, common area maintenance, real estate taxes, insurance and management. Depending on the lease structure certain operating expenses can be passed onto the tenants above a base year or based on the pro-rata share of space that they occupy in the building.
- Capital Expenditures – A reserve put aside for major expenditures i.e. roof, mechanicals, parking lot, and fixed assets is a prudent thing to keep in mind.
The building blocks can be used to calculate the net operating income as follows:
– Vacancy (based on Gross Rents and not Gross + Reimbursement)
– Operating Expenses
Net Operating Income
The ascertained NOI is projected out for a holding period and a revisionary value is ascertained by the following formula:
NOI (projected for the year beyond the end date of the holding period)
Divided by Capitalization Rate(based on local market and building Class)
The ? NOI for the holding period + Revisionary Value is discounted back to the present year based on a hurdle rate aka discount rate. To learn more about discount cash flow analysis, please visit this link.
Investing in Office Buildings: Asset Class Summary
Office Buildings, as an asset class, have a few defining characteristics that make it different than investing in other assets which are as follows:
- Long lease terms that can create stable income and create an implicit risk as the current rent paid is usually different from market rent which can be a good or a bad depending on which side of spectrum your rent variance falls.
- High volatility resulting from turnover and obsolescence risk.
- Undefined rollover risk leading to higher costs associated with lost rent, leasing commission and TI that can cause negative cash flow periods.
- Tenants in office buildings tend to occupy varying space sizes so a high density tenant who does not renew can cause severe negative cash flow for a building that requires access to reserve cash to carry the building during the vacancy period.
- Propensity of lending institutions to provide lower LTV debt capital therein requiring a higher equity check which can be a barrier to entry
Office Asset Class- Q3 Trends
Dr. Calanog, Reis VP of Economics and Research, provides the following office sector update for Q3 2013:
- Office vacancy at 16.9%, down 10 basis points from the second quarter.
- Asking and effective rents grew by 0.3%.
- Seven out of the top ten metros ranked by effective rent are either tech or energy oriented.
- Continuing recovery expected over the next five years.
Dr. Calanog summaries that vacancies are still elevated, landlords have weak pricing power when it comes to pushing back and charging higher face level asking rents or taking away concessions. There are exceptions. There are tech and energy centric markets like Austin, Dallas, Houston, and the Seattle’s of this world being able to charge higher rents because they are experiencing stronger job growth overall, and enjoying a healthier office sector. In fact, in two recent papers that we published we found that effective rents rose at around twice the magnitude for tech and energy centric metros versus all others. To Read more go to: www.reisreports.com
Photo Credit: swisscan