An Introduction to Office Building Investing

An Introduction to Office Building Investing
A good investment portfolio includes a range of different assets including stocks, bonds, and alternatives like real estate, and an even better one includes a diverse selection of real estate that includes an allocation to office buildings.

Most investors are familiar with apartments.  We all live somewhere, either paying rent or a mortgage for the roof over our heads, handling expenses like gas, electricity, water, and real estate taxes.  We are, if you will, masters of the finances of a residential unit so the step to understanding apartment building economics is an intuitive one.  As a result, investing in apartments is often the asset class of greatest interest to real estate investors.

The relationship we have, however, with the office buildings we commute to is less intuitive than that we have with our homes, particularly the grand downtown office buildings we see defining the skyline of every city across the nation. We commute to our offices and take for granted that we have a place to park, that the air-conditioning is on when we get there, and that our offices have been cleaned somehow magically overnight. We don’t think about the roof leaking, or how the walls or corridors surrounding us were built, or that the elevators work, or how the bathrooms were designed.

We are removed from imagining such things because in an office building we don’t pay for anything; we are paid. The companies for which we work provide us with our daily bread and we expect them to provide us with a place to work.

Because of the sheer scale of a downtown office skyscraper, ownership of this asset class has historically been dominated by insurance companies, large financial institutions and the wealthiest of the wealthy in America.

Now that regulations have changed, and for the first time every accredited investor in America can invest in downtown office buildings, an introduction into the inner workings of office building ownership, leasing, and management, is warranted.

Office Building Ownership Structures

Office building ownership can be broadly categorized into two major forms. The first category is referred to as an “owner-user”, which are businesses that own their own and occupy their own buildings. The second category consists of landlord owners who own and lease out their buildings to one or more office tenants. Historically, this category has been dominated by ultra-high-net-worth individuals or families and financial institutions, like endowments and insurance companies. Public companies such as Real Estate Investment Trusts (REITs) also successfully invest in large office buildings around the US and that has traditionally been only way an individual investor previously accessed the asset class, for all its pros- and cons.

You’re more likely to encounter owner-users in smaller buildings, such as the law firms or medical practices you might see along the road occupying the entire small building. In this case, it’s not so much being in the real estate business, but being in the medical, legal, or whatever other business, and happening to own your own real estate.  In some cases, large corporate campuses are owned and occupied by the corporations themselves.

Landlord owners tend to own larger office buildings, from the hundreds of thousands of square feet into the millions of square feet. Some of these owners hire third party property managers that take care of the operations of these complicated structures. Other landlords, like Feldman Equities, are vertically integrated and have in-house property managers.  These vertically integrated owners prefer self-management because the scale of their building ownership helps us to reduce operating costs. Landlords like Feldman Equities can leverage their size to get better rates for many of the operational maintenance costs.

In terms of the buildings themselves, there are a lot of diversity in the kinds of buildings that fall into the office building asset class. These include everything from 20+ story downtown high rises to single story buildings in rural areas. As important as the shape of the building is how it’s classified.

Quality Classifications

Office buildings are grouped by subjective classifications that are determined by the quality of the building and the way the brokerage community perceives and represents it to prospective tenants. This measure also presents a picture of the potential value of the property from, not only the perspective of leasing brokers and their tenant clients, but also to lenders and investors.

Classifications typically go from Class A to Class C. Class A office buildings are the highest quality buildings and are usually in great locations.  They are typically not more than 40 years old (with some exceptions).  Class A buildings are well-maintained, and often feature a modern design. How each class is defined is subjective, with some properties fitting into different categories depending on who you ask.

An example of this is Wells Fargo Center that we own in downtown Tampa. It is a modern looking 22 story building that was built in 1985.  It is in incredible shape, has been perfectly maintained, and is equipped with the modern features you would expect from a newly constructed building. You walk into the lobby and the quality of the place is obvious. We call that feeling of quality and class when you walk into a building the ‘psychography’ of the building. That said, there are currently two new buildings that are being built in downtown Tampa.  As a result, while we will continue to call Wells Fargo Center a Class A building, some people might consider it a B simply because of its age, regardless of the quality and location.

Class A buildings have the highest value and valuations are typically based upon lower cap rates than class B buildings. They tend to be stable, highly investible properties that both lenders, institutions and leasing brokers are eager to work with. Taking one step down, class B buildings are still investible, but they have a noticeable difference in psychography. You walk in and you can tell it’s not a modern, well-maintained building.

If a building has evidence of functional obsolescence, it is usually categorized as a class B or class C building. For example, an office building with low ceilings will almost automatically fall into lower categories of building.  A Class C building is the lowest quality office building, which is often poorly located, or has outdated building systems and poor upkeep.

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Who Are Office Building Tenants?

Clientele for office buildings range from small businesses renting a single space of 500 ft.² to corporations taking up an entire floor or multiple floors of a high rise building. In a well-run multi-tenanted office building, there is a good mix of large and small tenants with at least one major anchor tenant signing a long-term contract. These anchor tenants provide the advantages of stability and credit, enhance prestige, and drive smaller tenants to the building through reputation by association – if a major name branded tenant has its name on the building, that tenant’s credibility extends beyond its doors.

These stronger anchor tenants typically have very strong credit, which give an office building owner more borrowing power and valuation options. When it comes time to refinance a property with a 15-year long lease with a highly credit-worthy anchor tenant, lenders might offer a lower fixed interest rate. As of the date of writing this article, that could mean a fixed interest rate as low as 3.75% instead of an interest rate of about 4.25%. A building’s tenants’ credit directly impacts the level of trust a lender extends and serves to reduce the lenders risk, as well as reducing risk for the institutions and individual investors that own the building.

During a recession, the quality of the building’s tenants and their financial stability and credit are paramount. Many landlords learned this the hard way in 2008. That recession hit harder than the ones we’d previously weathered in the 1990s and early 2000s, and many smaller office clients went bankrupt. Lenders realized that the landlords’ rent roll wasn’t as strong as they thought, and credit became more expensive or dried up altogether.

To survive recessions, the seasoned office building owner will ensure that their buildings have stable tenants with strong credit and that occupancy stays high by keeping lease length terms longer.  Feldman equities has had a policy of aggressively cutting rents as needed to keep its buildings fully occupied. Another key risk mitigation is to reduce leverage and seek long-term debt maturities at today’s low fixed interest rates.

City Center St Pete

Typical Lease Structures

In contrast to apartment buildings which typically have one year leases, office building leases tend to be much longer. These longer lease terms contribute to investment stability and security. Typically, office space leases average 5-7 years. The larger the tenant and the more tenant improvements they’re asking for, the longer the lease will be.  These longer lease terms permit the landlord to amortize the cost of the improvements. Leases for larger office tenants with large upfront construction costs can extend to 10-15 years.

Some leases are structured as “gross leases” which require the landlord to pay for all of the costs of operating the building, including electricity cleaning, payroll, real estate taxes etc. In contrast, some leases to single tenants that occupy an entire building are structured so that all of the operational expenses passed through to the tenant. This category of lease is referred to as “triple – net”.

Vacancies in office buildings are costly. If a building experiences vacancy, the empty spaces still need to be maintained and serviced until they’re filled. Vacant space must be presented to prospective tenants in the best possible shape. As a result, landlords need to spend considerable sums of money to make the vacant space look more presentable. This might involve such improvements as new carpeting, new lighting, painting and the installation of new modern open ceilings. Clients coming in may not like thr layout from the last tenant, so every vacant space may potentially need significant tenant improvements before someone else will use it.

At Feldman, we emphasize tenant lease renewal as being of primary importance. By managing a property well and giving tenants a great experience, they’re more likely to renew their lease once the renewal period comes around. With over a century of experience in the real estate industry, and more than 40 years owning and managing large scale downtown office buildings, we have learned that our return on investment is substantially increased over the long run, and our buildings become even more recession resilient, when client retention is the focus of our business.  Some of the ways that we ensure tenant retention is that we require all of our property managers to regularly take out their tenants to lunch in order to survey them and to find out what is needed and wanted. Following these lunches, Repairs or complaints are immediately addressed.

Our leasing teams encourage existing tenants to take expansion spaces, but always require the expanding tenant to extend lease terms. Often these extensions have enabled us to weather the next recession.

Office buildings that I are, in many ways, very similar to running and operating an apartment building. In both cases, tenant stability is very important not only because it makes good economic sense, but because the best pathway to longer term stability is to ensure tenants are happy where they spend so much of their lives.  Over the decades and generations here at Feldman, we have found that the investment in excellent property management has always paid dividends, enhancing our returns during good times, protecting the downside during recessions, and enabling us to amass wealth for ourselves and our investors in the long run.

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