A recovering economy and more workers returning to the office are two factors generating renewed interest in office buildings for sale. Many investors looking for offices for sale are surprised to learn that office rent growth has been steadily increasing year-over-year despite the pandemic, while office-using employment is on the rise.
Why Investors Like Office Buildings
Buy-and-hold investors seeking stable cash flow, inflation protection, and depreciation benefits to reduce taxable net income often invest in office buildings.
Stable cash flows
Office building lease terms typically run for 5 – 10 years, providing office building investors with bond-like returns without the cost and inconvenience of annual tenant turnover. The cost of relocating a business from one office location to another can be prohibitive. An office building tenant often has a built-in incentive to renew the lease instead of looking for new office space for rent, making an office for sale an attractive investment.
Multiple lease structures
An office building for rent may offer gross, modified gross, or triple net (NNN) lease structures, each with distinct advantages, depending on an investor’s objectives. Office building leases can be written to protect the landlord from inflation by passing part or all of an office building’s operating expenses through to the tenant, in addition to annual base rent increases.
Commercial real estate like office buildings depreciates over 39 years, creating a tax shelter for real estate investors. For example, if the value of an office building (excluding the land) is $1 million, an investor can write-off $25,641 in depreciation expense to reduce taxable net income. That’s why an office building for sale is often viewed as a potential depreciation tax shelter.
Office Building Investing Basics
Office buildings come in all shapes and sizes, and exist in nearly every commercial real estate market in the US. According to Cushman & Wakefield, there are over 5.5 billion square feet of office space in the country, with more than 32 million square feet currently under construction.
Because the office building asset class is so huge, investors often categorize office buildings by class, size, and tenant type or use:
Office buildings classes
- Class A: New or like-new “trophy properties” with the latest features and amenities, usually located in the central business district (CBD) of large urban areas, occupied by the best tenants.
- Class B: Slightly older office buildings well maintained and in good condition, often occupied by local or regional tenants. May offer the opportunity for value add improvements to generate additional rental income.
- Class C: Older office buildings requiring significant remodeling and updating, sometimes located in business areas that have lost their luster. Class C office buildings may be good candidates for repositioning into mixed-use projects or conversion into multifamily property.
Size of office buildings
Office buildings can range from one to over 100 stories in height. There are single-level or storefront office buildings, low-rise office properties of two to three floors, mid-rise with up to 24 floors. High-rise office skyscrapers tower above, such as the 1,776 foot tall World Trade Center in New York City or the Willis Tower (formerly the Sears Tower) in Chicago with 1,450 feet of high-rise office space.
Office building types
Office building types are often characterized by the types of office tenants leasing the space. According to the Appraisal Institute, office buildings types are classified as:
- Business park
- Condominium building with multiple office units
- Creative or office loft
- Medical office buildings
- General-purpose office properties
- Research and development
- Other office space such as mixed-use developments with office, retail, and residential space
Three Types of Office Building Leases
Office building leases are generally structured in one of three main ways:
- Gross leases benefit the tenant by including everything (such as utilities, janitorial, and maintenance) in the monthly rent and may be used by office landlords as short-term leasing solutions until a long-term tenant can be found.
- Modified gross leases are a gross lease variation that pass through some operating expenses to the tenant, such as annual increases for common area maintenance, property or real estate tax, or insurance.
- Triple net leases (NNN) include a monthly base rent plus a pro rata charge (based on the percentage of space a tenant occupies) for the three nets of maintenance, property tax, and insurance.
Office Building Investing Terms to Know
When analyzing a potential office building, there are several terms that buyers should know and understand to help make the right investment decision:
- Gross rent is the annual rent that landlords can collect if tenants fully lease the office building 100% of the time.
- Effective rent factors in potential rental income lost to vacancy when space is empty between tenants, additional rental income from amenities such as parking, and bad debt expense when a tenant does not pay the rent.
- Operating expense is the landlord’s ownership costs for common area maintenance (CAM) expenses such as repairs, janitorial, landscaping, parking lot, utilities, property taxes, and insurance.
- Net operating income (NOI) is calculated by subtracting operating expenses (excluding mortgage or debt service) from the effective rental income.
- Cap rate is a ratio that calculates annual investment return of an office building by dividing the NOI by the office building value or sales price.
- Gross building area is the size of the office building in square feet and includes rentable office space plus common areas such as a lobby, mailroom, public restrooms, and elevator shafts.
- Gross leasing area (GLA) is the percentage of an office building’s rentable gross space. For example, an office building may have 100,000 square feet of gross space but only 75,000 of rentable space, limiting how much rental income the building may generate.
- Price per square foot is the value or sale price of the office building divided by the size of the office building. Office building investors take care to calculate the price per square foot of an office building based on the GLA or rentable square feet rather than the gross building area.
- Tenant improvements (TIs) are alterations made to customize an office suite for the needs of a specific tenant. The landlord and tenant may negotiate an office lease to include a certain amount of TIs as part of the monthly office rent, with any ‘extras’ such as upgraded flooring paid for by the tenant.
Potential Drawbacks to Investing in Office Buildings
There are several advantages to investing in office buildings, but there are also some potential drawbacks to consider before investing in office space.
First, office lease rates and the demand for office space generally go up or down based on the strength of the local and national economy. During a recession, the need for office space can decline, and the rent tenants can afford to pay may decrease.
Office buildings with a large number of leases expiring soon e may create unexpected vacancies for an investor if tenants choose not to renew their lease. Finally, older office buildings may be difficult to lease if floor plans are obsolete. That’s one reason old office buildings can be a better choice for investors seeking value add and repositioning opportunities.
The Bottom Line
As the economy begins to recover and the US slowly leaves the pandemic behind, there are signs that the office market is also improving.
Recently, CBRE analyzed the prospects of the 12 largest US office markets based on key metrics including: space requirements of active tenants, leasing activity, and the amount of office space available for sublease. Based on the survey results, some major office markets to consider are Los Angeles, Boston, Atlanta, Seattle, Manhattan, and Dallas/Fort Worth.