Office buildings can be a valuable asset in any investor’s portfolio, but they are not for the meek of heart or those that do not have significant cash at the ready. Yes they are generally comprised of triple net leases, meaning the tenant is responsible not only for rent, but also all other costs to maintain the asset through CAM, TMI or TAR (Total Additional Rent), which is very attractive.
However, office buildings also pose a unique set of challenges for investors that other similar assets such as retail plazas, industrial buildings, and apartment buildings do not. I refer to these challenges as ‘hidden costs’ because many investors significantly underestimate – or ignore completely – the impact these costs will have when calculating their return on investment.
By far the most common costs overlooked by investors are those associated with replacing a tenant or leasing any vacant suites. The repercussions of this miscalculation can be severe, as it can cause an investor to erroneously identify an asset as profitable.
As an example, let’s look at the case of Bob, a knowledgeable investor looking to purchase a mixed-use complex in Mississauga. He finds a great building with 95% of the building leased, including one tenant occupying two-thirds of the space and a lease expiring in five years. When calculating his return on investment, he made sure to factor in the cost of that tenant leaving at the end of their lease, figuring his costs to be between $20 and $30 per square foot to lease the space in a six to eight month time frame. Based on his calculations, he buys the building.
Fast-forward to twenty-four months after the tenant has moved out and Bob finds himself with only 45% of the space leased and his costs are running more like $35 – $45 per square foot to lease rather than the initial $20 to $30 he originally estimated.
How did Bob so grossly underestimate his costs?
His $20m-$30 was basically construction costs or lease hold improvements. He neglected to include carrying costs such as mortgage and taxes. How about permit fees, advertising? What about utilities and insurance that must be maintained, and of course those significant brokerage fees for those who bring you the tenants? Don’t forget tenant inducements like free rent that are very prevalent in today’s market place.
Keep in mind as well, this all requires cash direct from your pocket and up front.
What Bob neglected to do was properly account for all the items that needs to be factored in when calculating the cost of replacing tenants and leasing vacant space.
When he first purchased the building, he believed he could rent the vacant space for $9 per square foot and only invest $20 to $30 per square foot. Now in realty when all the numbers are accounted for he’s really only receiving $5 per square foot after investing $35 to $45 per square foot, not the original target of $9. Clearly, not the return on investment he had initially anticipated.
Think of office like a Mercedes Benz it is big and beautiful but expensive to own and to maintain. Further, each time ownership changes it takes a lot to keep it nice. The other asset classes are more like a Honda Civic. Less cost own, less to maintain, fewer changes in ownership, easier to sell etc…
While investor Bob was only an example, I’ve seen many cases over the past twenty years where landlords spent the money outlined above and ended up with current effective net rents lower than what the previous tenants were paying.
The main takeaway for investors considering acquiring an office building asset is to err on the side of caution when calculating your expected return. Always consider the ‘hidden costs’ involved in replacing a tenant or leasing vacant space, and have plenty of cash readily available to meet your needs.