In general, office buildings are viewed in three classes that relate to the building quality, not location:
- Class A: The newest, nicest, best in the market.
- Class B: Might be 1970s vintage with no “modern” features.
- Class C: The older, “unkempt” properties.
Office buildings are also viewed in the following categories:
- Urban: Downtown locations, typically with higher barriers to entry.
- Suburban: Fewer barriers to entry, but closer to new employment bases.
- Flex Space: Typically suburban; typically one story and used as part warehouse, part light manufacturing, with drive in doors and some warehouse space.
Factors to consider when underwriting an office loan:
- Lease-Up Period
- What will be the absorption pace on new leases?
- This needs to be calculated by looking at historic absorption levels, the strength of the local economy (job growth), and the supply of office space in the market.
- Occupancy Level: How well leased is the market? Will the subject property under or over perform in the market? Underwriting to the lesser of 95% or actual market vacancy.
- Rent Concessions: If the market is offering concessions, this deduction from revenue must be factored into the pro forma underwriting. Concessions are typically:
- Free rent
- Large tenant improvement package
- Tenant Improvements: The investor must understand the quality of the existing buildout/finishes of the building. Tenant improvements are expensive, and office buildings require the most tenant improvements. Typical improvements are:
- New leases: Typically the space is re-done at $25-$35 per square foot.
- Renewal leases: Typically the tenant will ask for new paint or carpet at $5 per square foot.
- Operating expenses
- Each investor must understand the normal expenses required to operate the building in the market.
- This is described in cost per square foot terms.
- The investor will need to recognize what expenses are “passed through” to the tenant and which are not.
- Also, leases may contain “expense stops” which limit the amount of expenses that can be passed through to a tenant.
- Typical office operating expenses are from $9.00-$14.00/square foot.
In general, there are five basic types of retail centers. These retail types are discussed below:
- Grocery anchor: Viewed as the most stable-everyone has to eat.
- Unanchored retail: Small centers of local tenants – these are the least stable, and trade at the highest cap rate.
- Neighborhood center: Local center, servicing surrounding residential areas, may have a grocery store.
- Power center: A destination center, typically with a combination of “big box” and local inline space.
- Regional malls: Large restaurants centers, normally with multiple anchors such as department stores.
Retail Underwritings: Retail specific issues include the following:
- Tenant credit: Tenants have different financial strengths. The better tenants are “credit tenants.” The more credit tenants a property has, the more valuable the property.
- Co-tenanting provisions: Retail revolves around consumer sales. Thus, many tenants want to be next or in the same center as large, well known tenants who produce a lot of traffic, such as Target. Smaller tenants will have “go dark” provisions that allow them out of their leases if the anchor tenant leaves.
- Go dark/recapture provisions: If a tenant goes dark, the landlord will want the ability to “reclaim” or release that space. Some retailers will go dark as a defensive move and purposely not allow competition in the trade area.
- Percentage rents: The landlord collects a portion of the rent based on tenant sales.
Industrial properties are viewed as a “safe” asset class because it is very homogeneous. The differentiating factors in industrial properties are:
- Location to major transportation routes
- Ceiling heights: the higher the better for more storage
- Docks/bays, two types:
- Bays for tractor trailers
- Docs for delivery trucks
Rents on industrial properties are mostly driven by supply and demand. It is difficult to drive price via asset quality like in office and multifamily.
Multifamily property is viewed as the safest asset class. This is due to the following factors:
- Everyone needs a place to live.
- At some level, the sponsor can drive occupancy by lowering rent.
Multifamily drivers include the following:
- Vacancy factor
- Rent levels (prices)
- Concessions (i.e. free month’s rent, giveaways)
- Actual Vacancy: The amount of unoccupied space or square feet.
- Economic Vacancy: Economic vacancy is defined as the total vacancy when dark or vacant units and concessions are taken into account.
Total Potential Rent (Full rent at 100% occupancy)
Total Rent Collected
Total Economic Collections
Total Economic Collections
Total Potential Rent
Total Vacancy Cost
Economic vacancy cost/total potential rent = Economic vacancy
Debt service coverage is a very important concept to understand because every investor/lender wants to ensure that the NOI is enough to “service” all of the debt. For this assignment, provide the ratio guidelines for the four asset types discussed in this course. In addition, discuss how the DSC is used to provide lenders/investors guidance as to how much money to provide to the borrowers.