Office buildings can be a valuable asset in any investor’s portfolio, especially given that the leases are typically triple net, 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).
However, office buildings 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 costs of $35 – $45 per square foot to lease the remainder – keep in mind, this doesn’t include carrying costs such as mortgage, taxes and other outlays required to maintain the building.
How did Bob so grossly underestimate his costs?
What he neglected to do was properly account for basic landlord work that needs to be factored in when calculating the cost of replacing tenants and leasing vacant space. This work includes replacing items such lights, ceiling tiles, and T-Bar ceilings, as well as general clean-up and tasks required to get vacant space market-ready.
When Bob 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 he’s ended up renting the space for $5 per square foot after investing $35 to $45 per square foot. Clearly, not the return on investment he had initially anticipated.
THE COST OF REPLACING A TENANT
Let’s take a look at the actual costs associated with replacing a 10,000 sf and 5,000 sf tenant in a typical 50,000 square foot office building.
Now let’s look at the costs for replacing a tenant in a typical 50,000 square foot industrial building:
[For this example, assume that 5% (approximately 2,500 square feet) is finished office space, the entire building is vacant, and the lease term is ten years with an approximate leasing fee of $2 per square foot.]
Notice the difference in net rents between office and industrial buildings – this is generally the case that net rent for office buildings is higher.
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 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 and always consider the ‘hidden costs’ involved in replacing a tenant or leasing vacant space.