What is IRR in Real Estate?
When investing in an income-producing asset, it’s important to know how much money you will make as well as when you will receive it.
While the shift to remote working from home has been swift, the majority of office professionals believe that over the long-term tenants will seek to expand space for increased collaboration and interaction, while complying with new social distancing mandates.
As the saying goes, “It’s always darkest before the dawn.” That’s why now is the perfect time to win tenants and capture market share.
At the end of the Global Financial Crisis of 2007 – 2008, the Harvard Business Review (HBR) published an article titled “Seize Advantage in a Downturn”. The article noted that while not doing anything during an economic crisis is the riskiest response, taking random action can be almost as damaging.
According to HBR, a disorganized response can distract people from seeing the hidden but significant opportunities nestled among the bad economic news. In order to make the most of the opportunities during an economic downturn, investors and stakeholders should:
One of the best ways to seize the opportunities created by economic downturns is to aggressively manage the top line, focusing on cash flow from existing tenants and identifying ways to generate additional revenue by winning more tenants and leasing more office space.
It’s become apparent that the current economic crisis is different from the one a decade ago, with publications such as Forbes saying it will likely take several years for economic growth to return to pre-pandemic levels.
For owners and operators of commercial office space, that means that some of the tenant preferences and leasing strategies once thought to be temporary may turn into long-term trends. A recent report from NAIOP’s Commercial Real Estate Development Association describes the key trends in office leasing and the geographic demand for office space:
Office building owners should also be willing to offer tenants reasonable short-term rent relief, either through deferred rent that is repaid over the remainder of the lease, or a rent abatement in exchange for a longer lease term.
While it may seem counterintuitive, the best way to stabilize the top gross revenue line by staying full rather than holding out for the highest possible rent.
In part, that’s because there’s often a disconnect between what landlords and tenants view as ‘fair market rent’ during an economic crisis. Because of the disagreement of what fair office rent is, vacant space can sit on the market for a very long period of time. Much of the per square foot operating costs still need to be paid when the space isn’t generating any revenue.
Secondly, and most importantly as far as commercial real estate investors are concerned, overall ROI can actually be higher with lower rents that maximize occupancy. To illustrate this point, we’ll use the most recent data from the Tampa Bay Office Market Report Second Quarter 2020 from Avison Young.
According to Avison Young’s report:
Now, let’s look at how ROI is affected by holding out for the average rental rate of $31.11/SF and renting at a slightly lower rate of $29.55/SF (a 5% reduction in rent) in exchange for a faster lease-up time.
At the current office vacancy rate, we’ll assume it should take about 6 weeks to rent an available office space. That means the gross rental income over a one-year period will be $137,602 for a 5,000 SF office suite. However, if we can reduce the lease-up time to just 2 weeks by reducing the rent by 5%, the gross rental income over a one year period will be $142,067.
By focusing on staying full, the first year ROI is 0.36% greater by not holding out for the highest rent:
As the economy improves and other leases roll to market, lower average rents can be brought to market, which will improve the ROI even more. But the potential rental income that is lost by having space vacant longer and holding out for the highest rent can never be recovered.
Of course, there’s a lot more to keeping office space leased than just temporarily lowering the rent.
According to a new forecast from Cushman & Wakefield cited by CNBC, the national office market won’t get back to pre-Covid levels until 2025, though there will be variation between regions. While the number of remote and hybrid workers who split their time between working in the office and from home will increase, population and economic growth – as well as knowledge-based workers – should lead to a full recovery.
That means that office building owners would be wise to push for a ‘full court press’ by leveraging the power of marketing, leasing, and smart rent concessions to win tenants and capture market share:
During an economic downturn, the first thing most property owners do is cut back on marketing. After slashing marketing, landlords later find out the hard way that they usually have to spend much more than they saved in an attempt to recover.
While lowering marketing costs may help net operating income over the short term, as the recession drags on cash flows are reduced and property values are degraded due to above-market vacancy rates. In turn, this creates an opportunity for more sophisticated and well-capitalized office building owners to increase market share with more and better marketing:
A seasoned landlord leasing team has solid relationships with local tenants, commercial real estate brokers, and access to spec suites that many other agents simply don’t have. With an in-depth knowledge of the local marketplace and contact with key players in the community, leasing brokers can:
It’s always better to give ‘free rent’ up front rather than degrade your base rent over the entire term of the lease. To explain why, let’s revisit the ROI example used in the previous section.
This time, we’ll compare the effect on ROI when the landlord gives the tenant 6 weeks of free rent with the rent rate at-market versus agreeing to a rent reduction of 5% of the entire term of a 5 year lease:
This example isn’t just hypothetical.
As the recent U.S. MarketFlash report from CBRE notes, office lease concessions rose sharply in Q2 2020. However, by offering tenants creative up-front rent concessions, office landlords are able to generate leasing activity while keeping base rents for office space relatively stable. In fact, office base rents have declined by only 1.1% in major markets compared to one year ago. Notably, they continue to rise in Tampa Bay according to Cushman and Wakefield’s Q3 2020 Report.
Although remote working appeared to be an overwhelming success, it’s turning out that working from home isn’t such a good thing for many employees and companies. According to Business Insider, Microsoft’s work-from-home study discovered that meetings are too long and people are working more, leading to a potential loss of productivity and much more:
To be sure, many companies are saving money by having employees working from home. In the beginning workers reported feeling more productive. However, as S&P Global Market Intelligence notes, the longer the pandemic grinds on the more work-from-home productivity appears to be evaporating.
The lack of interpersonal contact is taking an emotional toll on employees working from home. That’s because the longer the pandemic lasts, the more anxiety about job insecurity increases when workers can’t see their managers face-to-face. S&P also believes there’s a good chance that some of the productivity gains companies claim don’t actually exist.
Increased productivity may be an illusion, simply because it is difficult to measure. For employees whose work is entirely output based, such as coding, productivity is easy to measure. But for white-collar workers in professional service industries, measuring productivity is much more complex.
The Emerging Trends in Real Estate Report is published jointly by ULI and PwC, and in its 42nd year of publication continues to be one of the most highly regarded annual industry outlooks for the real estate and land use industry.
In the latest 2021 Emerging Trends in Real Estate Report, Tampa/St. Petersburg is named as one of the top six “Super Sun Belt” cities for real estate investors and developers. Super Sun Belt cities are markets that are magnets for both people and companies, with strong growth, positive homebuilding outlook, affordability, and job prospects.
While the powerhouse economy of Tampa Bay continues to grow, the market is still affordable for businesses and residents. The cost of living index in Tampa Bay is nearly 10% below the national average, and the population has grown by nearly 2% over the past year while median household incomes have increased by more than 8% (Data USA).
The Tampa/St. Petersburg metro area is unique compared to many other major markets. Tampa Bay isn’t transit-dependent and is attracting big corporate relocations and net in-migration, a trend that’s likely to accelerate as the economy begins to recover.
Those are also some of the reasons why Emerging Trends in Real Estate 2021 ranks Tampa/St. Petersburg among the top 10 markets to buy and hold office property in.
As the Global CEO of ULI notes, “Times of great change always present significant opportunities.”
Smaller markets such as Tampa Bay will benefit over the long term due to shifting demographics and changes to working and living patterns that are being accelerated due to the pandemic. Although it may seem contrarian, Covid-19 is creating an ideal opportunity for agile office building owners and operators to win tenants and capture market share from the competition.
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