Commercial Real Estate and Office Building Fundamentals

Classifications of Office Buildings: A, B, and C

• Class A Buildings

  • Definition and Quality: These represent the newest and highest quality buildings within their specific market. They are characterized by superior construction and finishes.

  • Tenants and Rents: Due to their prestige, they attract the highest quality tenants (often large corporate users) and command the highest rental rates in the market.

  • Location and Amenities: Typically situated in "A" markets near large amenities such as high-end restaurants, shopping centers, and affluent residential neighborhoods.

  • On-site Features: These buildings offer premium amenities to tenants, including on-site gyms equipped with lockers and showers, and ground-floor retail spaces for coffee shops or restaurants.

  • Age: Generally, these buildings are no older than the year $1990$.

• Class B Buildings

  • Description and Age: These properties are typically older, dating from the $1960\text{s}$ to the $1990\text{s}$. Some buildings from the $1940\text{s}$ to $1960\text{s}$ may qualify if they have been significantly rehabilitated.

  • Management and Tenants: They maintain good quality management and stable tenants despite their age.

  • Investment Strategy: Value-added investors often target Class B buildings. If well-located, these properties can be returned to "Class A glory" through strategic renovations, such as improvements to the facade and common areas.

• Class C Buildings

  • Characteristics: These are older buildings located in less desirable areas. They are often in a state of disrepair and require extensive renovation.

  • Market Performance: They command the lowest rental rates and take the longest amount of time to lease out.

  • Investment/Development Potential: These are frequently targeted as redevelopment opportunities, including conversions into affordable housing or hotels.

  • Leasing Terms: Owners typically take tenants on an "AS IS" condition. There are no Tenant Improvements ($TI\text{s}$) provided because the tenants generally have low credit and represent a high risk for default.

Specialized Office and Industrial Buildings

• Medical Buildings

  • Usage and Zoning: These are strictly used and zoned for medical use or hospital systems.

  • Construction Complexity: While they lack aesthetic "bells and whistles," they are expensive to construct. Costs are driven by requirements for individual bathrooms for tenant use, backup generators, heavy power for medical machinery, heavy plumbing, and specialized lab space for specimens.

  • Location and Value: Value is highly dependent on proximity to Hospital Systems or Universities.

  • Ground Leases: These are often situated on Ground Leases, where the land is rented for a long duration, allowing the University or System the option to expand in the future.

  • Design Specifications: These buildings feature much wider hallways for gurneys and significantly larger elevators than standard office buildings.

• Industrial Buildings: Warehouse and Manufacturing

  • General Intent: Designed for industrial practices including manufacturing, warehousing, Research and Development ($R\&D$), Third-Party Logistics ($3PL$), and distribution.

  • Warehouse Specifics: Generally large, one-story structures with high ceilings.

    • Clear Heights: Average clear heights range from $18\,ft$ to $40\,ft$. Newer products can reach up to $60\,ft$, particularly for high-credit firms like Amazon that require vertical stacking.

    • Older Products: Buildings from the $60\text{s}$, $70\text{s}$, and $80\text{s}$ typically have clear heights below $24\,ft$.

  • Manufacturing Specifics: These do not requires as much clear height as warehouses. However, they are difficult to re-tenant because removing specialized equipment is costly and the buildings are often unfit for other users. Raising rents on older manufacturing properties is challenging due to low clear heights and roof-supporting column spacing.

  • Logistics: Parking ratios are small (approximately $1$ to $2$ spaces per $1,000\,sf$), but the truck turning radius is critical for ingress and egress.

• Flex Buildings

  • Definition: Designed for "flexibility," allowing a mix of office, assembly, and warehousing uses. They are easier to retrofit than standard warehouses.

  • Parking and Design: They typically feature a $4:1$ parking ratio per $1,000\,sf$. They have nicer landscaping and a larger percentage of office space compared to distribution warehouses.

  • Heights: Ceiling clear heights are slightly lower, ranging from $14\,ft$ to $24\,ft$.

• Research & Development (R&D) Buildings

  • Components: A mix of office space, testing areas, and smaller warehouse space.

  • Requirements: Higher power needs for testing equipment. Construction is often highly specialized.

  • Financials: Tenants pay much larger rents due to the complexity of construction and high $TI$ (Tenant Improvement) costs. Proximity to Universities or Hospital systems is ideal.

Ownership and Investment Structures

• Single Tenant Property

  • Fully occupied by a single user. Can be delivered $100\%$ occupied or vacant at the close of escrow.

• Owner/User Building

  • The owner acquires the building for their own business operations rather than paying a landlord.

  • Financing: Frequently financed through government $SBA$ programs ($7A$ or $504b$). These programs allow for a down payment as low as $10\%$, compared to the standard $30\%-50\%$ for investment deals.

  • Deal Size: Most $SBA$ deals are completed below $\$5\,MM$ , with local majorities transacting below $\$3\,MM$.

• Leaseback (Sale-Leaseback)

  • A transaction where the owner-operator sells the building to a buyer and then becomes a tenant for a specified term (typically $3$ to $20$ years).

  • The Capitalization Rate ($CAP$ rate) for these deals depends on the term of the new lease and the starting rent.

Valuation, Brokerage, and Financial Modeling

• Broker Opinion of Value (BOV) & The "Deck"

  • Institutional sellers and $REIT\text{s}$ often provide data to three brokerage houses to receive competing evaluations before selecting a firm.

  • Evaluation Requirements: Rent Roll, Year-to-Date ($YTD$) Profit and Loss ($P\&L$), prior year $P\&L$, reconciliations of tenant expense reimbursements, records of major capital improvements, outstanding repairs, and current vacancy leasing activity.

  • Due Diligence Walkthrough: Used to determine the cost and time to backfill vacancies. Major cost items include the roof, parking lot, $HVAC$ systems, and restroom upgrades.

  • Debt Considerations: Current loans must be reviewed for expensive prepayment penalties. Some loans are assumed rather than paid off; assumption requires a larger down payment and is time-consuming.

  • Offering Memorandum (Deck): The converted $BOV$ used to market the property to investors.

• Capitalization (CAP) Rate

  • Definition: A derivation of value, direct capitalization, or return on investment ($ROI$).

  • Formulas:

    • $\frac{\text{NOI}}{\text{Price}} = \text{CAP Rate}$

    • $\frac{\text{NOI}}{\text{CAP Rate}} = \text{Price}$

  • Purpose: Used to attract buyers and for sellers to identify returns, establish pricing, and identify "upleg" caps for $1031$ exchanges.

• Stabilization and Occupancy

  • Fully Stabilized: Defined as having less than $10\%$ vacancy.

  • Stabilized Occupancy: The long-term ($9$-$12\,mo$) average occupancy expected after open market exposure under competitive conditions.

  • Lender Requirements: Fannie Mae and Freddie Mac require a $90\%$ stabilization rate to issue a loan.

• Vacancy Factor

  • The amount of gross revenue lost due to vacant space. It is an allowance item on pro-forma statements, calculated as a percentage of gross revenue.

  • Factors include rollover rates (market rent adjustments), credit/collection issues, and rent increases.

Measurement Standards and Definitions

• Net Rentable Square Feet ($SQFT$)

  • Usage: Used primarily for leasing.

  • Definition: Usable square footage (within the four walls) plus the tenant's proportionate share of the common areas.

  • Formula Logic: Rent is paid on the rentable square footage, not just the usable space. Common areas include hallways, lobbies, public restrooms, and fitness facilities.

• Gross Rentable Square Feet

  • Usage: Used primarily for sales.

  • Definition: The total square footage of a building from the outside finish inward. Includes usable space, rentable space, building core, elevator shafts, and maintenance/operation areas.

• Core Factor and Load Factor

  • Core Factor: The percentage of common areas. Calculated as:

    • $\text{Core Factor} = \frac{\text{Rentable Square Footage}}{\text{Usable Square Footage}}$

  • Load Factor: The specific amount of space a tenant pays for based on the $R/U$ (Rentable/Usable) ratio.

• Financial Analysis Terms

  • Argus Run: A specialized software program used for vacancy factors and complex financial modeling (more advanced than Excel).

  • Leveraged: Using financing/borrowed funds to increase the return on equity.

  • Unleveraged: An all-cash payment for a property.

  • Gross Potential Income (GPI): Gross revenue if the building were $100\%$ leased without accounting for costs.

  • Reimbursements: Costs incurred by the owner (e.g., repairs) that are later repaid by the tenant.

Engineering, Construction, and Improvement Costs

• Physical Specifications

  • Height: Standard ground-to-roof height is $9.5\,ft$, often with an additional $3\,ft$ for ducts. Other buildings range from $14\,ft$ to $16\,ft$.

  • Floor Plate: The size, layout, and usable space of a floor. A favorable floor plate usually has an open middle to maximize elevator access and tenant space.

  • Slab: A standard concrete slab is approximately $6\,inches$ thick.

  • Parking Ratios:

    • Office: $4:1$ per $1,000\,sf$.

    • Medical/Dental: $6:1$ to $8:1$ per $1,000\,sf$.

• Improvements and TI Costs

  • Build Out: The completion of improvements or construction finishes.

  • Tenant Improvement (TI): Interior improvements to meet user needs. Can be owner-subsidized or amortized into the rent. Generally, higher $TI$ leads to longer lease terms.

  • Average TI Costs for Shell Space:

    • Office: $\$25$ to $\$150/SF$.

    • Medical: $\$100$ to $\$200/SF$.

    • R&D: $\$200/SF+$.

• Expense Data (per $SF$ and % of Gross Income)

  • Office: $\$8$ to $\$12/SF$ ($55\%$ to $70\%$ of gross income).

  • Industrial: $\$3$ to $\$5/SF$ (up to $75\%$ of gross income).

• Absorption and IVP

  • Net Absorption: The change in occupied office stock over a specific timeframe.

  • IVP: Total amount of available space divided by the average number of sales per month. This figure estimates the number of months needed to exhaust current supply.

Financing Models and Debt

• Financing Types

  • Debt Fund: Short-term leverage of assets often used for distressed properties until they are "cured" and eligible for conventional financing.

  • Conventional Financing: Standard lending through banks or institutions.

  • Commercial Mortgage Backed Securities (CMBS): Large loans (typically over $\$20\,MM$, averaging $\$50\,MM$-$\$100\,MM$) that are securitized and sold to investors.

    • Management: Governed by a Pooling and Servicing Agreement ($PSA$). Controlled by a Master Servicer unless in default, at which point a Special Servicer takes over.

    • Conflict of Interest: Special servicers may benefit from defaults as they can acquire properties at discounts.

    • Terms: Offers $30$-year amortization but carries a heavy "Defeasance Penalty" for early repayment.

  • Insurance Loan: More flexible than $CMBS$ as the loan stays on the balance sheet. Generally uses a $25$-year amortization. Prepayment is called "Yield Maintenance."

• Market Indicators

  • 10-Year Treasury: Set by the FED; acts as a prospectus for the long-term economy.

  • SOFR (Secured Overnight Financing Rate): Replaced $LIBOR$. A measure of the cost of capital based on overnight collateralized securities. It is often a floating rate until the day of closing.

• Repayment and Debt Metrics

  • Interest Only: Borrower pays only interest for a set term; the principal remains unchanged.

  • Balloon: An oversized final payment due at the end of the loan term because the full amount was not amortized.

  • Seller Carry-Back: A loan provided by the seller to the buyer for a portion of the purchase price.

  • Debt Coverage Ratio (DCR):

    • $\text{DCR} = \frac{\text{NOI}}{\text{Annual Debt Service}}$

    • Must be greater than $1$ for positive returns.

Due Diligence and Leasing Formulas

• Due Diligence Reports

  • Phase 1 Report: An environmental inspection taking $12$ to $41$ days.

  • Phase 2: Follow-up inspection to confirm contamination and cleanup requirements.

  • PML (Probable Maximum Loss): Determines seismic movement risk.

    • At $20\%\,PML$, a buyer is required to carry earthquake insurance.

    • At $30\%\,PML$, a lender will typically refuse to lend on the building.

• Lease Structures

  • Gross Lease: Landlord covers all operating expenses (taxes, insurance, maintenance, utilities, janitorial).

  • Modified Gross Lease: Tenant pays base rent plus a proportional share of certain costs (e.g., utilities, insurance). Common when multiple tenants share meters.

  • Triple Net (NNN): Tenant pays base rent plus their pro-rata share of all operating expenses, including taxes, insurance, and common area maintenance. Tenants are also responsible for reimbursing roof and structure maintenance.

  • Double Net (NN): Tenant reimburses operating expenses except for the roof and structure.

  • Absolute Net: Landlord receives one "net" check; the tenant handles all expenses directly with no annual reconciliations through the landlord.

  • Expense Stop: The starting amount of operating expenses specified for reimbursement.

  • Base Year: The starting year for calculating expense increases in a lease.

Construction and Land Use Concepts

• Entitlements: The legal rights to develop a property, commonly referred to as zoning.

• Floor Area Ratio (FAR): The ratio of the building's total square footage to the square footage of the land.

  • $\text{FAR} = \frac{\text{SF Building}}{\text{SF Land Usage}}$

• Concrete Tilt-up: A construction method using a "shell" that allows for a quick build.

• Ground Lease: A land lease lasting up to $99$ years.

• Utility Metering:

  • Master Meter: One meter for the entire building.

  • Separate Meter: Individual meters for each tenant, allowing for precise reimbursement and monitoring of usage.