A good building at a full price against a rough building at a price that looks like a mistake

Question

Anyone evaluating passive office exposure right now is facing a market that has pulled apart into two distinct trades. 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. For a passive investor with a modest check, two shapes tend to 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. The price reflects that it already works, and the return depends on rents holding and the scarcity of good space continuing. The second is a share of a secondary building bought at a price per foot that looks impossible, say 55 percent leased at 70 dollars a square foot, an 11 or 12 percent yield on paper. That yield exists because the re-leasing cost is enormous and nobody knows what the space rents for in five years. Every dollar of it can go straight back into tenant improvements and commissions. For anyone newer to the terms: going-in yield is first year net income divided by price, tenant improvements are what a landlord spends building out space for a tenant, and commissions go to the brokers on both sides of a lease. In office, those two costs together are the single biggest expense most passive investors underestimate. Both positions are defensible, and the honest answer depends on how much conviction an investor has in their own read of re-leasing risk versus their willingness to pay for certainty that already exists.

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

Neither is the harder answer here, partly because this property type resists easy judgment. The part that's hard to 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 does it have to be rebuilt from scratch every time?

A good building at a full price against a rough building at a price that looks like a mistake

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