Single tenant office at a 7.9 cap with 3.5 years left, what do I reserve for the rollover?

Question

Broker sent me a 22,000 sf single-tenant suburban office. Regional bank operations back office, been in the building 11 years, 3.5 years remaining on the lease, 2 percent annual bumps, absolute net. Asking $4.1m which is a 7.9 percent cap on in-place NOI of about $324k.

The cap looks generous for a credit-ish tenant and that's exactly what worries me. My rollover math:

If they leave at expiry, market TI for a new office user in that submarket is $60 to $70/sf on a seven-year deal. Call it $65 on 22,000 sf, that's $1.43m. Commissions at 5 percent of a seven-year term on $16 net rent adds roughly $123k. Downtime of 12 to 18 months costs me the NOI plus about $7/sf of carry on empty space, so another $500k to $650k all in.

That's $2m to $2.2m against a $4.1m purchase price. Half the price is a contingent liability that shows up in year four.

So how do people actually price that? Do you underwrite a renewal probability and blend, do you take the full downside and re-derive what you can pay, or do you just refuse anything under six years of term? And if the tenant does renew, what's a realistic renewal TI, because I've seen $15 to $25/sf quoted for a sitting tenant and I don't know if that holds in a market where the landlord has no alternative.

hannah_west29 · Answer

I'd run it as two deals and see what the seller is really selling.

Deal one is 3.5 years of $324k with a 2 percent bump, discounted. Call that roughly $1.15m of contracted cash flow. Deal two is a 22,000 sf vacant suburban office building in year four, which is what you own the day they hand back keys.

So the question becomes what a vacant 22,000 sf building in that submarket trades for. If comparable vacant stock is moving at $70/sf, that's $1.54m. Add your $1.15m of income and you're at $2.7m against a $4.1m ask. The gap is the market pricing a renewal that you have no contractual right to.

On renewal TI, the $15 to $25/sf number is real when the tenant has options and is choosing to stay. A back office with 11 years of specific fitout, generator, raised floor maybe, has high moving costs, and that's the one thing in your favor. Find out what their capital in the space is. If they've spent $2m on their own build-out, the renewal is far likelier and cheaper than your downside case. If it's open plan and desks, they can be gone in a weekend.

Also pull the estoppel early. "Absolute net" in an offering memo sometimes means net with a landlord roof and structure obligation, and on a 1990s single story that roof is a $180k to $250k line item.

megan_doyle15 · Answer

Dumb question maybe, but if the tenant is a bank, isn't the lease guaranteed by the bank itself? I thought that made the income safe regardless.

renee_dubois · Answer

@rigging the guarantee only covers the 3.5 years they've promised to pay. It says nothing about whether they sign again, and a credit guarantee on a term that's ending is worth exactly the remaining rent.

Quill, the thing that jumps out at me from small multifamily is that I get 12 chances to be wrong a year and you get one chance every seven years. My worst unit turn is $6k and three weeks. Yours is $1.4m and a year. Same idea, completely different survivability, and it means your reserve can't be a percentage of revenue, it has to be a dollar amount tied to the actual rollover date.

Single tenant office at a 7.9 cap with 3.5 years left, what do I reserve for the rollover?

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