Office buildings have had a tremendous run over the past several years selling at the lowest cap rates not seen by most and capital has been abundant. REITS, hedge funds, private equity and even pension funds have jumped to own. Low interest rates and cash have been the driving force for many of these sales. I don’t think you can find one above a 6 cap. But wait. Most of these sales were driven by single tenant users and government in the CBD of a few MSAs such as DC, NY, San Francisco, Boston and a few others. So, the marketers are trying to sell every office building for a 6 cap. This is where due diligence comes in. Below are 5 insights you should include in your due diligence before you pull the trigger.
After you finalize your due diligence, can the NOI support the asking cap rate? Most don’t but there are different types of buyers with different assumptions and return rates. So the price may be appropriate for them. This make making an offer difficult to impossible because sellers have this 6 cap ingrained in their heads. You may have to make 100 offers to get 1 buy. Brokers will drop you if you do this because they and the sellers want a 30 to 45 day close. If you want to stay in the game due diligence has to be done before contract signing.
Except for the banks you will need 20 to 35% down plus closing. Of course you should have your lender already lined up. Where there is an assumption available I would take advantage of that for the 1% fee. If the price has a large gap between the loan and purchase price see if the seller will hold a second so you can meet your down payment criteria. It’s hard to get financing on suburban, multi-tenant office buildings today since most community banks are licking their wounds. Owner occupied not so bad because of SBA. Bank of America came to me the other day and said they had 100% financing for lawyers.
Don’t become one of them. Expenses too high to pay the mortgage. Every week I read where some owners are giving back their buildings to the lenders. This usually occurs in full service buildings where your due diligence just didn’t work. Owners have gotten more savvy and included expense stops in their leases. Full service buildings have to be realistic on their expenses. $6 psf does not cut it anymore, try $8, $9 or $10. Turnover for office buildings is the most expensive cost in any real estate class. Every new tenant wants a new lay out. There goes $150,000 on a new 5,000 sf space. TI allowances are never enough to cover this cost so be sure to include turnover cost in your due diligence or ZOMBIE, by the way this is a real real estate term.
Multi-tenant buildings have different wording in their leases due to initial negotiations. It’s important to have an accurate lease abstract on every lease in your due diligence package. Terms, conditions, increases, early outs, options to renew, redecorating, insurance limits, use, guarantors, tenant responsibilities, subordination language, hours of operation to name a few. A lease abstract will help in making reasonable assumptions about your imminent investment.
Market, below, above. Rents vary in different markets. They change with the tide. If you have a tenant paying above market rent on a 10 year lease and it expires in one year or less don’t assume that tenant will continue to pay the same rent. Tenants are smarter today. In your due diligence the best assumption will be market or below. Of course they still may vacate. Negotiations are key here. This is hard for institutional investors because they are more confident than the rest of us. Some lenders won’t let you rent below a certain sf amount and if you do or have to you may have a special servicer knocking on your door. Call every comparable building in your market and see if the existing rents are sustainable. This should be in your due diligence report. Rents control the cap rate.