Ins and Outs of Office Real Estate
In commercial real estate investment, Office Real Estate can be an excellent addition to a real estate investor’s investment portfolio.
Table of Contents
- Categories of Office Real Estate
- Factors to Consider when Investing in Office Real Estate
- Advantages of Investing in Office Real Estate
a. Higher Income Potential
b. Higher Equity Potential
c. More Tenants, Less Risk
d. Security Advantage
e. Excellent Appreciation Value
- Disadvantages of Investing in Office Real Estate
a. Longer Investment Time Horizon
b. Tenant Turnover
c. Heavier Investment
d. Thorough Research Required
e. Fewer Tax Incentives
- How To Invest in Office Real Estate
a. Indirect Investment
b. Direct Investment
In commercial real estate investment, Office Real Estate can be an excellent addition to a real estate investor’s investment portfolio. Office Real Estate refers to properties used by businesses for their day-to-day administrative operations and typically does not include industrial properties such as factories or warehouses. Office Real Estate may be a building owned by one or more investors who lease it out to one business as a whole, or through individual units to multiple companies, generating revenue through rent from each occupant.
Categories of Office Real Estate
Office Real Estate is typically split into a few different classes, which may provide a good indication of the type of investment and whether one should invest in the property.
Firstly, Class A office properties are relatively newer properties that are usually superior in appearance, quality and located in ideal areas, such as the CBD. Class B buildings, while somewhat inferior to Class A office spaces in these aspects, reflect this in their lower prices, which can be attractive for investors looking to restore these properties. Meanwhile, Class C office spaces are in suboptimal locations and conditions and require more maintenance since these buildings are typically over 20 years old.
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However, Class A buildings are not the only attractive investment option. They may be inaccessible for individual or smaller investors who are not able to afford it. As such, Class B and Class C office spaces may be more appealing. Class B offices are a good starting point for newer investors as they are more affordable than Class A options, but do not require as much maintenance as Class C office properties. Class C properties may provide good returns as well, particularly for investors using a value-add investment strategy who are willing to invest in the refurbishment of the property, which can generate higher returns in the long run.
Factors to Consider when Investing in Office Real Estate
Purpose of Properties
Office properties can be built for different purposes, which can impact the type of existing and future tenants it can attract. Office Real Estate may be suited for research and development, medical purposes or business parks. This can capture larger volumes of business tenants who may want to operate near other businesses in their sector for convenience and ease of conducting business.
However, these specialised sectors lack diversification and may restrict the types of tenants one can attract and limit rental opportunities.
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Office Real Estate assets can range in size from low-rise office buildings between 1 and 3 storeys to mid-rise buildings between 4 and 24 storeys, and even high-rise skyscrapers of above 25 storeys. In addition, the square footage of a property can have a significant impact on the amount of rental income that can be generated from the property.
This includes the Net Leasable Area (NLA), as well as the Gross Leasable Area (GLA), which is made up of both the NLA and other common areas within the building. Individual or smaller investors should begin with low-rise to mid-rise office properties as this is a feasible option with sufficient returns, but still requires a bit of investment capital.
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The occupancy rate of a property is an important consideration in Office Real Estate Investment as it directly impacts the rental revenue. Office Real Estate buildings may come unoccupied or pre-leased, which means there are existing tenants that are continuing their lease during the sale of the property. This guarantees rental income for these units but may limit the investor if there is a need for renovations or maintenance on the property.
However, before investing in a pre-leased property, one should check the lease terms and lease expirations of each tenant. The Weighted Average Lease Expiry (WALE) of a property, is a metric that could be used to measure vacancy risk via a calculation of the length of existing leases and the proportion of rentable area occupied. If an office property has tenants whose lease is ending soon, this should be factored into the investment considerations.
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Comparables refer to other properties with similar features to the potential investment property, whose value can be used to provide an indicative value of the property to investors. Normally, approximately 3 comparables are used to determine an appropriate asking price for a property. Through this comparison, investors can gain a better understanding of the value of the property to ensure a fairer deal within the market.
Comparables can also be used to calculate a fair rental price. Comparable rental prices of other properties in the area can provide an indication of over-rented versus under-rented properties, which is when a property’s gross rent does not match its estimated rental value.
The cap rate of a property is an indication of the rate of return a property investment is expected to generate. The cap rate is derived through dividing the property’s Net Operating Income (NOI) by its current market value, representing the property’s yield over a one-year time period.
This percentage shows an investor how long it will take for the investment to break even, taking into account maintenance and tax costs, providing a comprehensive analysis of the cash flow. An investment property’s cap rate should be comparable to that of other properties in the area.
However, cap rates are not static and may shift depending on changes in its NOI, location, as well as the quality and grade of the building. Further market conditions would also play a role in the adjustments to cap rates.Sign Up at RealVantage
In every investment, on a case-by-case basis, there would be merits and demerits to a deal. In the following two sections, we list out on a broader basis some of the factors that one should take into account when considering this asset class.
Advantages of Investing in Office Real Estate
1) Higher Income Potential
Due to the larger property size and tenant volume, the annual return of Office Real Estate is much higher. The annual return of commercial real estate ranges from 5% to 15%, compared to other investments such as stock dividends, which are between 2% to 3%. In commercial real estate, multifamily properties have returns at the lower end of the range, while suburban office spaces tend to generate returns on the higher end.
2) Higher Equity Potential
Equity built through commercial real estate is typically increased through leverage, with borrowed capital through loans. This allows for higher returns, with the expectation that profits from the property are higher than the loan’s payable interest. Commercial real estate loans also tend to be easier to acquire from banks due to the higher prospects of a stable income flow from the real estate properties.
3) More Tenants, Less Risk
In office real estate, the higher number of tenants equates to less risk since each tenant only makes up a percentage of the property’s income, so vacancies do not cause a 100% income loss. Also, many office real estate leases use a Triple Net Lease (NNN), whereby the tenants are liable for net building expenses, net taxes and net common area maintenance fees.
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4) Security Advantage
Commercial real estate properties also provide more security than other assets. There is a relatively stable demand for most commercial real estate properties, meaning a fairly stable income source. Furthermore, there is a guaranteed value associated with the property, including its land value, property value and appreciation from property improvements.
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5) Excellent Appreciation Value
Commercial property investments also have a strong potential for value appreciation. Investors in such properties have a significant amount of freedom over the property and can change the look or features of the property to increase its value, depending on the local laws and regulations in the region.
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Disadvantages of Investing in Office Real Estate
1)Longer Investment Time Horizon
In relation to the longer lease terms, Office Real Estate investments require a longer investment horizon. This means that the capital invested in the property will take a longer time to pay itself off and generate profits, making it a relatively illiquid asset. Investors should keep this investment horizon in mind when investing, as value-add strategies are impractical for the property type, and may even result in a loss, especially for newer or less experienced investors.
2) Tenant Turnover
During tenant turnover, a tenant leaves, and the office space is left vacant, so revenue cannot be generated. Also, the time and cost required to secure a new tenant can lead to large losses, making tenant turnover a major deterrent for potential investors. The tenants in office real estate may also be more difficult to source since some properties may attract a specific tenant type, which can increase the time taken to find a tenant - resulting in a loss in revenue.
3) Heavier Investment
Investing in Office Real Estate typically requires a significant financial commitment, especially in comparison with a residential property. Because of this, investing in Office Real Estate as an individual investor may not be viable. There is also a higher cost associated with maintenance of an Office Real Estate property compared to residential properties, and maintenance loans may be required to perform these upkeeps.
4) Thorough Research Required
Before investing in Office Real Estate, investors would have to conduct thorough research on the potential investment properties, since there are more laws on these property rentals, and their uses, depending on the zoning of the property. There would be other costs associated with investing in the property besides its actual purchase price, such as local property taxes and additional fees for investors.
5) Fewer Tax Incentives
Office Real Estate properties typically do not receive the same tax incentives as residential properties do, so property taxes, rental taxes and the lack of loan repayment rebates may be a factor for potential investors to consider.
How To Invest in Office Real Estate
Investors may indirectly invest in Office Real Estate through stocks or market securities that invest in office property stocks. These include Real Estate Investment Funds (REITs), which are companies that deal with income-generating real estate. They allow individuals to earn passive income from REITs, without needing comprehensive knowledge of the sector. However, investors in REITs do not have an ownership stake in these real estate assets and are therefore indirect investors in real estate. Exchange-traded funds (ETFs) are funds that invest in a few different asset types. In real estate, industry ETFs invest in real estate stocks, most commonly REITs, and can be traded at any time.
High-net-worth individuals who have an in-depth understanding are commonly the ones purchasing properties directly since it requires a considerable amount of funds and comes with a certain level of risk. Individual investors are also generally more involved in the investment process and take on more responsibilities, including sourcing for the property, acquiring loans and dealing with property management duties such as collecting rent and property upkeep. These individual investors may not have access to certain opportunities that are only made available to larger institutional investors, and are therefore limited in their investment options,
Although Office Real Estate investments often require a larger amount of capital, the option of investing into this sector is still accessible for investors with smaller investment amounts through co-investment. Real estate co-investment platforms allow individual investors or collectives to contribute investment capital towards an investment opportunity in exchange for partial ownership in a property. This provides these investors with access to larger and more lucrative direct / indirect investment deals that the investors would otherwise not get access to. Investments into the asset could be both direct and indirect types.
This is an up-and-coming method of investing in real estate that removes the hassle for investors, while providing a freedom of choice in properties not afforded by REITs or ETFs. This also provides opportunities for cross-border investment, allowing investors to diversify their portfolio in different markets, reducing the risk and opening up different investment options for individual investors.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.