Good building at a full price, or a rough building at a price that looks like a mistake

Question

I manage buildings rather than own them, and I get asked this by owners often enough that I want to see how the room splits.

Office has pulled apart into two markets. Newer well located space with real amenities is getting the leasing, and available prime space is getting scarcer in a lot of metros. Older commodity buildings are where the vacancy sits and where the loan trouble is showing up, with office delinquency on securitized loans hitting record levels recently.

So for a passive investor with a modest check, two shapes come across the desk.

The first is a share of a prime asset. High occupancy, strong tenants, a low going-in yield, maybe a 6 handle. You're paying for the fact that it already works. Your return depends on rents holding and on the scarcity of good space continuing.

The second is a share of a secondary building bought at a price per foot that looks impossible. 55 percent leased, $70/sf, an 11 or 12 percent yield on paper. The paper yield exists because the re-leasing cost is enormous and nobody knows what the space rents for in five years. Every dollar of that yield can go back into tenant improvements and commissions.

A few definitions for anyone newer. Going-in yield is first year net income divided by price. Tenant improvements, or TI, is the money the landlord spends building out space for a tenant. Commissions go to the brokers on both sides of a lease. In office those two together are the biggest single cost most people underestimate.

Both cases are arguable. Vote and say why.

samantha_ruiz · Answer

Secondary, but only if the reserve is funded at close and sized off a broker's actual TI quote for that submarket rather than a number the sponsor typed. The problem with the cheap building isn't the price, it's that the reserve is almost always the line that gets trimmed to make the returns presentable. I've seen $40/sf used where the leasing brokers were quoting $75 plus four months free.

Prime at a 6 makes me nervous for a different reason. You're buying the current story about scarcity, and if a couple of big users hand back floors in your submarket, that story adjusts fast and there's no yield cushion under you.

raj_mehta14 · Answer

I voted neither and I'll admit part of that is that I don't understand this property type well enough to pick. The bit I can't get past is that the cheap building's yield is quoted before the money that has to be spent to keep it leased, so it isn't really a yield in the way a note coupon is a yield. Is there a standard way people quote office returns net of that capital, or do you just have to rebuild it yourself every time?

Good building at a full price, or a rough building at a price that looks like a mistake

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