December 2, 2020
For high-yield office buyers, the popular play of renovating older properties and
leasing them up at higher rents needs fine-tuning — and a lot more patience.
In the later years of the real estate bull market, strong leasing demand made it
possible for investors to push up rents quickly and turn a profit on a newly renovated
office building. But the coronavirus crisis has thrown a wrench into that strategy,
raising questions about future occupancy levels and the ability to increase rates.
Now, buyers and owners must shift their sights and expectations. “Investors
need to look at a longer time horizon,” said Eric Enloe, a managing director and
capital-markets lead in JLL’s valuation and advisory practice. “You have to be
Given the likelihood of tempered rents and slower lease-up periods, buyers with
value-added strategies no longer can count on a quick turnaround when it comes to
stabilizing a property. Instead of an immediate revenue boost, they’ll need to plan for longer hold periods, with the return coming later upon a sale or refinancing.
“Your implementation of the plan may be a little slower in the next 12 to 18 months, because the tenants don’t know what they are going to do,” said Paul Gaines of Accesso Partners, a commercial real estate firm in Hallandale Beach, Fla.
With the move to remote working, tenants are reassessing their need for space and, as leases expire, committing to shorter terms.
From July through September, 55% of leasing activity consisted of renewals, increasingly in three- to five-year terms, according to JLL. “Give backs” — tenants reducing space — contributed to a 28.9 million-square-foot decline in occupancy, which dropped to a nationwide average of 86%, while space available for sublease continued to grow.
As a result, firms such as Morning Calm Management are still pursuing deals, but with an adjusted timeline. The Boca Raton, Fla., investment shop recently agreed to buy an office building in suburban Washington leased largely to biomedical and pharmaceutical-related firms with an eye toward upgrading amenities and, eventually, boosting rents. “We assumed zero new leasing done in the first year and very little lease-up during the investment period,” said Mukang Cho, Morning Calm’s founder and chief executive.
His firm and others are focusing on improvements that position properties to compete for a thinner pool of tenants when the pace of leasing picks up again. “We’ve got to do more to make less,” Cho said. “The world is more competitive now than it was pre-Covid … We are going to be fighting for the smaller universe of tenants that are going to be out there. But tenants’ leases still expire, so there’s always someone to pursue.
”Investors also must spend more time and money on what they think tenants will need when they eventually return to the office. That includes new cleaning protocols, measures that enable social distancing, and upgrading ventilation systems to improve air quality.
Gaines of Accesso said his firm is prioritizing some upgrades over others to budget expenses while adding features that will make it “comfortable” for tenants to return. “It’s not in our mind that this is going to be temporary,” he said. “It is going to be with us for a while.”
That’s potentially costly for older, outdated buildings that were targeted by buyers for upgrades. Already, office properties were registering increases in capital expenditures that have been eating into net income. General maintenance expenses and leasing-related improvements grew from 4% of net income from 2010 through 2014, to 5.4% from 2015 through 2019, according to a report by Green Street, the parent of Real Estate Alert.
Add to that the expense of outfitting an older building to comply with pandemic-related safety protocols — and, in some locations, new environmental regulations that increase maintenance costs — and the deal may not pencil out for some buyers.
“The obsolescence risk for office buildings is increasing,” said Daniel Ismail, senior analyst and office team lead at Green Street. Should occupancy and rents decline simultaneously, “you are going to have the inevitable universe of office buildings that are not worth the cost,” he said.
Meanwhile, the ability to find favorable lending terms for value-added plays has diminished — even with today’s historically low rates.
“It used to be that rollover in a [building’s leases] was an opportunity — it was a chance for a landlord to capitalize on rent spikes. Now that attitude has completely shifted,” said Mark Godfrey, a senior managing director overseeing the Northeast region for valuation and advisory services at CBRE. “Lenders are not looking at value-add leasing opportunities. . . . They do not want to participate in that rollover risk.”
Buyers need to find a compelling story — such as a rent roll that turns over later rather than sooner — before making a purchase. “To make it financeable, you need income streams that bridge the gap through this Covid period of uncertainty . . . rental revenue that gets past the more challenging economic conditions,” Godfrey said.
Overwhelmingly, market pros agree that for these types of deals to work today, a buyer will require a discount upfront — and keep the faith that an economic recovery will bring a pop in returns at the end. “You need to have conviction there’s equal or more residual value upon an exit,” said Cho of Morning Calm.