Handling Due Diligence On An Office Property
It can be daunting for novice investors or even experienced investors to conduct due diligence on office properties. Office properties can be likened to a puzzle with pieces constantly changing in size. There are many lease expiration dates, floors that have been demolished in very different ways, and one tenant is looking to grow, another to contract, and a third who wants to move. It can be overwhelming without a straightforward approach.
Although office due diligence requires more strategic planning than other asset types, it is still manageable, especially if you have an expert to guide you.
Top 10 Aspects Of Office Due Diligence:
Conduct a desktop analysis.
Conduct a field evaluation on the site.
Creates a stacking strategy by reviewing leases.
Check for any tenants.
Learn about the target market for tenants and build broker relationships.
Develop underwriting.
Examine the competitive set.
Assess the town.
Think about the impact coworking has on the tenant experience.
Assess the COVID-19 factor.
But before we can get started, you need to have a strategy in mind. It is essential to assess the current situation and identify the tenants you want to attract. You must also have an intention to your process before you purchase.
Due diligence is about minimizing risk. So let's just take it one step in a while.
Conduct A Desktop Analysis
The good news is that the desktop analysis, the first step of the process, can be done remotely from your home, office, or any other space you have access to. This phase is where you will want to begin digging into all the information you have about the property and the market it is located.
You'll Need To Assess The Market And Submarkets For Office Property Investments:
Office vacancy rate.
Office absorption rate. This is the total space leased/vacated in a given period.
Construction pipeline for new properties.
Average office rental rate That aligns with your potential purchase ).
The significant employers that are based in this area have an impact on the overall economic trend.
You should also consider the sublease space available. This includes available units and those that aren't publicly advertised but are still available for sublease. You may find that there is more supply than you think. You will need to contact a local broker professional to get information about these shadow spaces. More details on that later.
Also, you will need to evaluate the property's operating expenses. Even more important, you will want to know what costs you will incur when you rent out your space. For example, what is the average market rent for tenant improvements? What concessions are available, such as free rent? Of course, these factors may change depending on market conditions, but it is possible to understand the trends.
Most of this information can be found by analyzing third-party reports
There are no set metric thresholds that can be used to determine items like the vacancy rate of a property. Each property must be evaluated with its market. Different markets show different trends. The trending average vacancy rate in New York City is usually less than 10%. Others have a higher vacancy rate, which is north of 10 %.
Volatility is something you need to be aware of. Does the vacancy rate fluctuate a lot? It could indicate that pricing is changing. It's essential to take into account both historical and current metrics when performing a desktop analysis.
Conduct A Field Evaluation For The Site
If the desktop analysis is conclusive, you can jump into the field to evaluate the property.
This phase is both detailed and thorough. But, unfortunately, there isn't anything you can't see. It starts at the outside and continues to the infrastructure of your conduits.
These Are Some Of The Things To Consider When Evaluating An Office Property:
HVAC systems:
Is it modern and efficient, or do you need to replace them? This can lead to a high price tag, so make sure you carefully evaluate it. This is especially true in COVID-19 when tenants are more concerned about air quality and circulation.
Technology:
Are your tenants able to connect quickly, and do they have the bandwidth they need for their internet?
Facade and roof:
There have been many beautiful buildings with massive leaks in their facades. To make sure that they are waterproof, you will need to inspect the roof and the facade. It is expensive to replace a roof on office property.
Phase 1 environmental assessment:
Review this report to ensure there aren't any relevant issues.
Fire suppression systems
Lighting and water:
Both lighting and water systems should be modern and efficient.
Parking and transportation:
It is essential to evaluate parking ratios for suburban properties and the general condition of garage facilities. Access to public transport is a critical consideration in urban areas. It is essential to think about how tenants enter the building from the garage or via public transport. How does the tenant first encounter the property?
A Day In The Life
This last question is key to understanding the experience of being a tenant on the property.
Prospective investors need to walk the property as if they were a tenant and take the time to consider every step that the tenant takes, from the exterior to the office space. It is essential to consider the experience of the lobby, both from an aesthetic and security standpoint. How efficient is the entry process? You should also consider elevator systems from an engineering standpoint as well as their overall appearance. You should also assess stairwells to make sure they are in good condition, well-lit, and attractive.
There are also common corridors that run through each floor. Everyone talks about the footprint that tenants lease. They spend a lot of time going back to their space. How do corridors look?
It is also essential to consider the common area bathroom. Are they newer or older? Although each tenant is necessary, the property features make a more significant impression on tenants. Therefore, they will value the space-based upon some of these common areas.
When entering the actual office suites, it is essential to look at how recently the units were renovated to keep up with current office design trends. It is necessary to determine how many glass partitions have been installed in the building compared to drywall partitions. Also, you will want to decide whether it is possible to raise the ceiling. These elements create an open and light-filled space that modern office tenants prefer.
Review Leases & Create a Stacking Strategy
Next, you will need to analyze the in-place leases. You should evaluate rental rates and expiration dates and review clauses in each lease that grant tenants certain rights, such as expansion, contraction, and renewal options.
Next, take the information you have gleaned by studying these leases and convert it into a stacking map. A stacking plan shows the property with all its occupied and unoccupied units. The stacking plan offers every floor of the building. It should be color-coded so that it highlights when leases are due to expire—for example, purple for leases ending in 2025 and orange for leases ending in 2027.
This will allow you to see every space on the property. It will also help you plan how to deal with expired leases.
Here is where the jigsaw puzzle metaphor plays a role. The first step is to create a strategy for the office investor that will allow him to renew as many tenants as possible. It's almost always financially prudent to do this while also managing the shifting space needs of those tenants.
Creating a stacking strategy will help you to make that game plan. It will allow you to see and appreciate the future opportunities and threats to occupancy at your property, as well as the potential to generate revenue.
Although many programs can help you create a stacking plan for your business, making a basic version in Microsoft Excel or similar programs is possible. You don't have to make it the most beautiful thing. However, it should be helpful from a visual perspective.
Check Any Tenants
If the building is unoccupied, assessing the existing tenants will also be part of your strategy. After you have signed a letter indicating your intent to buy the property and obtained financial information about the tenants, this will be a step in the due diligence process. Although this information is not likely to be reliable, it will give you data about each tenant's credit and allow you to interview them.
Sometimes, a cash security deposit will be required for credit. Other tenants may also be protected by personal guarantees or letters of credit from financial institutions renewed annually. Nearly all public companies that have high ratings from independent credit agents or U.S. government tenants are preferred.
Higher credit ratings, personal guarantees, and lower default rates can reduce the risk of terminations and increase your ability to get reasonable financing terms for the transaction.
You can assess the viability of each tenant's business and their plans for their space during the interview phase. In addition, you can learn about their plans for space and how they are growing or contracting. This will help you plan your property leasing strategy and allow you to offer what they want well before the lease ends.
Learn about the target tenant market and establish broker relationships
Partnering with a local landlord broker is a great way to gain insight into potential tenants in your area and understand the target tenants of your property.
These relationships will allow you to identify which tenants are currently in the market and when your key target tenants' leases expire. This is a great way to determine who is nearing your target audience. It is a good idea to start cultivating these relationships during the desktop analysis phase. Local brokers can provide more details and nuanced insights regarding local market conditions.
Local brokers often do a lot of research about people, where they live, when they lease, and how much space is needed. This information can help you to understand your chances of attracting other tenants to your building.
This relationship will help you see the potential and develop your strategy for the property. It will also be helpful if you have vacancies in the future. These brokers will be motivated to reduce the time you have vacant space and ensure that you are aware of the market concessions that your competition is making. This will help you to make sure that your deal is competitive.
Develop Underwriting
Office property underwriting is more complicated than multifamily. It's not as simple as taking the current situation and making assumptions about rent growth. Let's take a look at the essential elements you will need to consider.
Hold Periods, Tenant Revenue/Expenses
First, determine your expected hold period. This is the time you plan to keep the property before selling it. Office investors typically base their underwriting on a 5- to the 10-year holding period.
After you have determined the assumed hold period, it is time to look at existing leases in relation to that period. This means that you cannot just examine the current rent roll, but you must map it over a set period.
From a revenue standpoint, office underwriting is about being thoughtful about what you expect to happen after the lease ends of in-place tenants. In other words, it is essential to make informed assumptions (based on the existing tenant assessment that we discussed in part one) about the tenants you anticipate will renew their leases at the property and those who are most likely to move. For example, what costs are you likely to incur to keep tenants at the property, such as for tenants who you expect will sign renewal agreements? Conversely, if you anticipate a tenant leaving, what costs will you incur to lease the space? This is part 1 of our series on building a stacking strategy for your property.
For any vacancies that are not yet filled, expenses for finding new tenants should include tenant improvement allowances and rent freebies. Brokerage commissions must also be included. A local brokerage firm can estimate these costs. In addition, they can give insight into market trends and current market concessions.
Operating Expenses
A critical factor in determining the income and expenses of an underwriting analysis is selecting whether the tenants or you are responsible for certain operating expenses.
Most office buildings, but not all, have a triple net (NNN) or triple-net structure to their leases. The tenants are responsible for all expenses, including cleaning, electricity, and taxes, within their own space and share of the shared space (e.g., hallways, lobby, etc.). For example, if a tenant occupies 10% of the total property, they are responsible for 10% of ordinary area expenses.
Tenant pays its share of operating expenses in future years that exceed base year operating expenses (the period in which a tenant is assessed when they take occupancy). These are commonly referred to as operating expense escalations.
This is where things get tricky. Tenants may be required to pay a certain amount of expense increases, or there might be exclusions. It is essential to understand the base year of each tenant and any restrictions on future operating expense increases. You should carefully review any operational expense clauses in the lease.
It's essential to compare what's happening in the market with your potential property's operating expenses. You'll need to confirm that the current operating costs and expected increases are comparable to the rental rate for the property. You could be tempted to rent out a property that has high operating costs.
Service Contracts & Building A Budget
You need to know what you want and what the cost of building it is. This will help you understand your experience. In addition, you will need to budget for services such as landscaping, security, and so forth. This is more than simply using the existing budget for your underwriting.
Many service contracts for office properties are long-term and may require you to keep specific contracts even after purchasing the property. You may also need to comply with union requirements in certain areas, especially in urban areas. These could require you to have a specific number of people on-site to provide certain services.
While you may want to have an open mind about how you approach the process of creating a budget for your property, it's essential to be aware of the constraints you will need to follow.
Software Solutions
Microsoft Excel and other similar programs can provide enough support for smaller properties with fewer tenants or spaces. However, it is worth considering loading all moving variables into an advanced program to assess your underwriting profile accurately, regardless of how many spaces there are or how complex the tenant rights are.
He said that the assumptions about tenant renewals and moves impacting the property evaluation are significant. Therefore, it is especially helpful to have these options loaded up and programmatic rather than being manual. He said that you might end up missing something if you don't have the right tools. Potential lenders may also want to see this level of detail about the property.
When it comes to choosing the right program, Argus is the best. I don't think anyone has ever used another program for modeling office investments.
Explore the Competitive Set
It is crucial to determine which office properties are your building's most competitive set, as with any real estate investment. After you have compiled a list, we recommend that you visit your competitors in person.
You should at least go into each building and check out the common areas and the lobby and amenities available to tenants. He said it was also beneficial to see a few vacant units within the building, as your direct competition will be on day one.
You should analyze the properties and gather information about their current tenants and their lease expiration dates. These details will give you some insight into potential tenants for your property.
It is important to examine new office buildings in construction or at the planning stage of the market to determine if they are competitive. Again, a local broker can often provide information about the supply chain. In smaller markets, where data is often difficult to find, and one additional property can significantly impact market dynamics, we recommend visiting the local city hall to review requests for permits, variances, and construction permits to uncover other development activity.
Assess the Municipality
It is essential to evaluate the general appetite of the local municipality for office construction projects, in addition to the supply issues that may be present during the planning or construction stages. Their approach may seem more permissive than usual, which could affect your ability to compete and the rate you can charge.
This is just one aspect of the local community you need to consider. You should also examine the local employment drivers and search for stabilizing factors such as a tendency to see certain companies congregating in that area.
It is crucial to know what the municipality is doing to attract new businesses and retain existing ones. For example, there could be tax credits, tax breaks, or infrastructure development.
It's becoming increasingly important to think about how the municipality prioritizes the needs of technology-oriented businesses. For example, is the city emphasizing technology infrastructure to attract tech-related companies to this area?
Reach out to as many municipal officials and the town planning & zoning commission as you can. You will be able to gain information about all the city elements and some of the qualitative features that could help businesses attract and retain customers. For example, what programs are in place to make the community a better place to live and work? Some areas are more thoughtful about these features than others.
Taxes are another aspect to consider when evaluating whether a municipality falls under municipal jurisdiction. Taxes have been a significant expense for cities in the past. This is because they can take advantage of the income generated by office buildings. Therefore, we recommend determining the current tax burden of the property and the likelihood that it will rise during the hold period. This complexity is why we recommend that you engage the services of a third-party consultant, even for smaller properties.
The Impact Of Coworking On Tenant Experience
In the last decade, there have been two major shifts in the office market. Investors should be aware of these changes as part of their due diligence—the growing use of coworking spaces and the increased emphasis on tenant experience.
Coworking Spaces
Coworking isn't a new idea. It has existed in some form for decades. However, over the past few years, with the presence of several large coworking offices like WeWork, it has become a prominent presence not only in cities but also in the suburbs.
Coworking operators should not be viewed as their enemy or competition by office investors. It is essential to find out how coworking is used in your potential property's local market.
Does it absorb demand from your main office market? Is it an overflow situation where a tenant moves around in their footprint?
Knowing the types of people who frequent local coworking spaces will help you to determine if they pose a threat or not.
Coworking is often a problem due to the type of users your property leases out to or potential tenants you hope to attract. For example, if your property is primarily made up of medical offices or more extensive, established tenants, then you are likely to be relatively safe from coworking competition.
The Tenant Experience
Another critical issue regarding coworking space is whether or not you want one added to your property. This neatly aligns with our next point: the tenant experience.
There has been a shift in the office industry towards service-oriented approaches to understanding and responding to tenant preferences over the past few years. As a result, you can find a wide range of services and features, including conference rooms, event spaces, food courts, yoga classes, and coworking options.
It is essential to assess the building that you are buying. You should also look at what it has and how it compares to your existing tenant base. If it doesn't, you can look at ways it could be improved.
It is a good idea to verify what services are explicitly guaranteed in lease documents. Sometimes, the property owner might have made a promise to provide food services. Some tenants may be entitled to a reduction or elimination of these services or the right to end their lease. You should be aware of the assurances given and confirm that you can meet them.
Many investors believe that the concept of an experiential office does not apply to their property and only applies to large-sized properties. He felt that this view was too narrow. It's there to a certain extent, or it's waiting in the wings. So, if your goal is to invest in the office market for five to seven years, you shouldn't ignore its importance.
Evaluate The COVID-19 Factor
Coworking spaces and other experiential office features are almost insignificant compared to the enormous question that hangs over the office market.
The Short Answer Is:
The most knowledgeable people in business are considering it. Many people believe that the footprint will shrink, but this is still unknown.
This uncertainty should not deter an intrepid office investor. This is separate from the question, "Can you still underwrite an offer?" Instead, you must continue to apply the basic principles for office investments and consider the risk profile a little differently.
Tenants may be forced to reduce their footprints in the short term, but we expect businesses to grow in terms of space requirements over a more extended hold period as new jobs are created. The potential for some contraction is part of the long-standing puzzle nature of owning an office building. A tenant who gives up space could allow another tenant to rent it or make the property more livable.
This has been an essential aspect of owning an office building. It's not like a one-bed or two-bed situation. Instead, it's 'hey, you have a floor that has multiple users with contracting and expanding requirements.' So you have to deal with this aspect.
