Office Space

Investing in Office Buildings

Office buildings can be an exciting prospect if you're thinking about purchasing commercial real estate as an investment. Our nation's business activities are oriented to an office environment. Each profession, government agency, financial institution, corporation, or business needs an office to house it service activities. 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.

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.

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. This approach is relied upon when other approaches won't work because the property doesn't have any comparables or an income stream.

The second method is the sales comparision approach. This is analogous to the “comps” that realtors use when setting residential home prices. The sales comparison approach, involves estimation value by analyzing other like properties recently sold in the market. The sales comparison approach is used when the investor can find several comparable properties recently sold. Sometimes there are not any recently sold comparables. In that case, the investor will need to rely on another method or use older comparables.

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.

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.

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.

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).

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.