An Introduction to Investing in Office Commercial Real Estate

February 11, 2022
15 minutes

An Introduction to Investing in Office Commercial Real Estate

Commercial real estate (“CRE”) has demonstrated the potential for stable historical returns, low correlation to the public markets, and income. However, while commercial real estate could be a helpful in diversifying a traditional investment portfolio, risks should be considered.

The term commercial real estate, in its simplest form, is any non-residential property intended to generate profit from cash flow or appreciation of price. Commercial properties may have strict zoning requirements regulated by various local ordinances.

There are many subcategories and niche commercial real estate properties; however, there are four main property types, office, multifamily, industrial, and retail. Understanding the pros and cons of investing in these CRE properties is helpful in evaluating what best fits your investment preferences and risk tolerance.

Since commercial real estate investing is new to some investors, in this article, we will highlight classifications of office buildings, tenancy considerations, typical lease structures and key terms. We will also outline some recent trends within this property type.

Traditionally, investing in office buildings has been unattainable for individuals due to the large upfront capital requirement. However, Real Estate Investment Trusts (REITs), syndicators and online crowdfunding platforms have opened access to professionally managed office investment opportunities.

U.S. Office Market Snapshot

Before getting into the nuances of office real estate attributes, let’s review some market conditions and trends within the space. There is no doubt the pandemic has reframed the definition of collaborative work.

Benefiting from technology upgrades, many companies have adopted hybrid work models. Others have even redesigned space to ensure employees work safely. In addition, landlords are considering flexible space to meet the demands of tenant office needs.

According to leading global real estate services firm CBRE, “U.S. office market activity strengthened in the second half of 2021, and the momentum likely will continue in 2022.” As unemployment fell in 2021, lease transactions increased, and rents leveled out nationally on average, according to CBRE.

One of the many bright spots recently has been in the Southwest and Sunbelt area. CBRE predicts the most significant demand for office space in these locations due to net inflows of migration and additional office requirements from tech companies moving to the area.

Despite several positive indicators, CBRE, expects the delivery of 53M square feet of inventory in 2022 will present some headwinds for some landlords.1

CBRE Rent Growth versu vacnacy

Office Buildings Classifications

Office buildings are classified into Class A, Class B, and Class C. These classifications are usually determined by the brokerage community and are typically based on the properties’ age, amenities, and location.

  • Class A buildings are typically new developments or have undergone significant renovations in recent years. These properties are often in central business districts and conveniently located near major highways or public transportation to ease commuting. Another allure of class A office buildings is the modern amenities. You can often find high-end dining, gyms, and upscale lobbies that tenants and guests can enjoy. Since class A spaces are typically the highest quality office buildings in the area, they attract better tenants and command a higher rent.
  • Class B offices are slightly lower quality when compared to class A. These buildings are more outdated, but still have amenities that attract high-caliber tenants. While class B buildings might be found in major cities, they are typically located outside downtown areas or in suburban locations. Rental rates are in-line with the market average and do not command a premium like class A properties.
  • Last, class C are office buildings that can be outdated and require significant capital expenditures near-term. The locations are in suburban or less desirable locations to attract a skilled workforce. Class C properties have minimal amenities.

Aside from the descriptive quality, office buildings can be categorized based on height. For example, offices can be described as a “high-rise” or “low-rise”. While each tenant will have their individual preferences, there is much to consider when investing in office buildings of various heights.

While the views from a high-rise building are impressive, elevators are required to transport guests, requiring ongoing maintenance cost and insurance. Low-rise offices may benefit from outdoor spaces where tenants can meet in a socially distant fashion if we consider the pandemic. Also, low-rise offices typically have separate entrances and are less dense.

A recent growing trend is co-working. Co-working tenants share the space typically on a month-to-month basis with the ability to increase or decrease desk space based upon business needs. Creative offices are designed to inspire innovation, flexibility and workplace collaboration. You may find an open concept, exposed beams or bricks, or polished concrete in creative office space.

Office Tenancy

Office tenants range from small businesses to large corporations. A building can be composed of a single tenant or multiple ones. Anchor tenants traditionally sign long-term leases and may be stable and credit worthy.

While some investors may be quick to say a diversified rent-roll that includes multiple tenants should translate into more stability, this isn’t always the case. For example, a single investment-grade tenant with a long-term lease in place may lessen the operational burden and vacancy risk. On the flip side, a landlord and lenders may prefer to stagger the maturities of lease terminations over time to allow re-leasing to occur through various phases of the macro-economic cycle.

Investors benefit from fully occupied properties through ongoing cash flow from operations and a sale. Vacancies are costly, and even empty space require maintenance while courting new potential occupants. Tidying up the space to be presentable for future tenants requires capital outflows from the landlord. Additionally, once the lease is negotiated and executed, tenant improvements (“TIs”) are made based upon the needs of the new occupant.

In many brokerage materials or investment memorandums, you may see a supplemental visual representation of tenants across various building floors. This is often referred to as the stacking plan. Also, the square footage of tenants and lease expiration may be included.

Office Lease Structures

Typically, office leases are longer in duration, approximately five to fifteen years for the initial term. There are usually annual rent escalators within the lease that help defray cost increases for operating the property.

Also, as a provision in the lease, the landlord may stipulate a set number of extensions for the tenant to renew at a predetermined increase or based on market rates. Typically, the longer the lease and larger the tenant, the more tenant improvements a lessee can negotiate.

While lease structures can be complex, we’ll touch on the three most common structures, gross lease, modified gross, and triple net lease. A gross lease requires the tenant to pay base rent while the landlord pays all the property level expenses such as utilities, taxes, insurance and common area maintenance.

Triple net leases require the tenant to pay the base rent and its pro rata share of costs related to the property. A modified gross lease is somewhere between triple net and gross.

Tenants are expected to pay some of the operating expenses in addition to the base rent. In general, rent is often quoted as price per square foot.

Trends in Office Commercial Real Estate

Now that we have a solid foundation on the classifications, tenancy, and lease structures of office buildings, we will highlight a few trends shaping the office CRE market.

Despite some setbacks during the pandemic, many remain optimistic around office real estate fundamentals.2 While some tech companies declared a commitment to remote work, many have been leasing and buying property at a rapid pace.

In September 2021, Google announced the purchase of a campus in Manhattan for $2.1Bn, which could be the largest office transaction in the U.S. since the onset of COVID. People want to connect – dine at a restaurant, get a haircut, purchase goods in person, and collaborate in meetings at an office.

Predicting where cap rates go in the future may be difficult, but some trends will be more pronounced in the coming years. Sustainable properties are attracting a higher quality tenant base and overall tenant experience.

Proactive sponsors incorporating property technology will help bolster portfolio and asset management capabilities.

Conclusion

Whether you are a seasoned real estate investor or just getting started, it can be challenging to know how to evaluate an office real estate investment. Hopefully, with this basic understanding of office commercial real estate, you can assess the benefits and risks more clearly.

While it is important to understand the fundamentals of office real estate, the sponsor’s ability to provide tenants with a great experience cannot be overlooked. Proactive communication and being attentive to the needs of tenants often helps with retention over the long-term ownership.

While the earlier phases of the pandemic might have discouraged some office real estate investors, new opportunities might present compelling entry points for individual investors to consider allocating to this asset class.

References

  1. Office market inches closer to its “next normal”
  2. Real estate billionaire Sam Zell says office space will recover ‘much faster’ than retail

by Jamestown Invest

Jamestown Invest is a direct-to-consumer platform, connecting U.S. individuals directly with real estate managed by Jamestown.

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