How To Conduct Due Diligence on an Office Property, Part 2

In part one of this two-part series, we covered the first five items of our top ten elements of the office due diligence process. To wit:

1. Conduct a desktop analysis.
2. Perform a field evaluation of the site.
3. Review leases and create a stacking plan.
4. Assess any existing tenants.
5. Understand the target market and establish broker relationships.
6. Develop underwriting.
7. Investigate the competitive set.
8. Assess the municipality.
9. Consider the impact of coworking and the tenant experience.
10. Evaluate the COVID-19 factor.

If you’re a savvy reader, you’ve probably already divined the focus of this article, i.e., chart-toppers six through 10 in the above countdown. Once again, Jack Brundige — chief of portfolio management with Waypoint Real Estate Investments and an individual that has conducted this process for more than 24 million square feet of office properties across the United States — will act as our Dante in navigating this often complex, but (nearly) always manageable process.

According to Brundige, the underwriting process for an office property is significantly more complex than it is for other real estate asset types, such as multifamily. It “isn't just taking the current situation and throwing some rent growth assumptions on that side of the ledger,” he said. Let’s break down the most critical elements that you’ll need to review.

Hold Periods and Tenant Revenue/Expenses

“The art of office underwriting is being thoughtful about and really understanding what you think is going to happen upon lease expiration of the in-place tenants.”

Jack Brundige, chief of portfolio management, Waypoint Real Estate Investments

Firstly, you’re going to want to determine your anticipated hold period; in other words, how long you expect to own the property before reselling it. Most office investors will typically develop their underwriting based on anywhere from a five- to a 10-year hold period.

Once you’ve determined your assumed hold period, you’ll want to analyze the existing leases relative to that timeframe. In other words, you can’t just look at the “current rent roll, you actually have to map it out over a course of a defined hold period,” Brundige said.

Brundige added that, “the art of office underwriting, from a revenue perspective, is being thoughtful about and really understanding what you think is going to happen upon lease expiration of the in-place tenants.” In other words, you need to make educated assumptions (informed by the existing tenant assessment we covered in part one) about which tenants you expect will renew at the property and which are more likely to relocate. For tenants that you anticipate will sign a renewal, what costs will you absorb to keep them at the property? Alternatively, if you expect a tenant to vacate, what expenses are you likely to incur to lease the space to a new company? Getting a solid grasp on this jigsaw puzzle of varying lease expirations, unit sizes and tenant predilections is just one reason Brundige recommended building a stacking plan for the property in part one of this series.

Expenses for securing new tenants for any existing or expected vacancies should include concessions such as tenant improvement allowances and free rent, as well as brokerage commissions. Estimating these costs further justifies developing a relationship with a local brokerage firm, as it can provide insight into current market concessions, as well as their expected trend pattern over your hold period.

Operating Expenses
Another factor that substantially informs both the revenue and expense sides of an underwriting analysis is determining whether you or the property’s tenants are responsible for various operating expenses.

In most office properties, though certainly not all, leases are structured on a triple net (NNN) basis. What this means is that the tenants are typically responsible for expenses (e.g., cleaning, electricity, taxes, etc.) both within their space, as well as for their proportionate share of the building’s common space (e.g., hallways, lobby, etc.). For instance, if a tenant’s unit represents 10% of the total property, that tenant is responsible for 10% of the common area expenses.

Moreover, according to Brundige, “the tenant pays its proportionate share of the amount by which operating expenses in each future year exceed operating expenses in the base year (the annual period assessed at the time a tenant takes occupancy).” These are often referred to as operating expense escalations.

However, this is where things can get a little tricky. “There can be some caps or exclusions on what expense increases tenants are required to pay. So, it's important to be sure that you understand what each tenant's base year is, and what restrictions there may be on passing through future operating expense increases to them,” Brundige noted. For this reason, make sure you closely review the operating expense clauses in any existing leases for the property.

In addition to assessing operating expenses at your prospective property, Brundige advised that it’s also important to “cross-reference what's going on in the market.” Similar to how you approach the property’s rental rate, you’ll want to verify that both existing operating expense costs and any anticipated increases are aligned with the market average (relative to the level of service being provided at the property). Otherwise, you could risk purchasing a property with high operating expenses, which could deter potential tenants.

Service Contracts and Building a Budget
“In order to understand what your experience is going to be in owning a building, you have to make sure you understand exactly what it is that you think you need to provide and come up with your own view of what it's going to cost,” Brundige said. This means developing your own budget around services at the property — such as landscaping, cleaning, security, etc. — rather than merely utilizing the property’s existing budget in your underwriting.

However, Brundige cautioned that service contracts at office properties can often encompass long periods of time, and you could “be required to continue on with certain contracts after you buy the property.” Further, in some areas, particularly in urban locations, there could be union requirements that you’re obligated to conform with “that require a set number of people to be on site for certain services.”

Accordingly, while you’ll want to take an agnostic perspective to the process of building a budget for the property, you’ll also want to make sure you’re informed about the existing constraints that you’ll have to adhere to.

Software Solutions
For smaller properties that don’t have a large number of spaces or tenants, Microsoft Excel and similar programs can provide sufficient support to develop your underwriting. However, “at some point, based on the number of spaces or complexity of the tenant rights” it becomes advisable to consider “loading all the moving variables into an [advanced] program to accurately assess the underwriting profile,” Brundige said.

He added that because the assumptions around tenant renewals and relocations impact the property evaluation so significantly, it is particularly helpful to have those options “loaded up and programmatic, as opposed to being manual.” Otherwise, he said, you could end up “in a situation where you could miss something quick.” There’s also a good chance that any potential lenders will want to see that level of underwriting detail for the property.

As for what program to utilize, Brundige said that while there are certainly other options available, “Argus has been the standard for years, and I actually don't know of another program that anyone's ever used for modeling office [investments].”

“Get into a couple of the vacant units in the building, because that's really what your direct competition is on day one of your investment.”

Jack Brundige

As with any real estate investment, it’s crucial to establish which office properties represent your building’s competitive set. Once you’ve developed a list of true competitors, Brundige advocated for an in-person perusal of your rivals.

“I think you have to at least get into each of the buildings and see the common areas and the lobby and the amenities that are available to the tenants,” he said. He added that, if at all possible, it’s also beneficial to “get into a couple of the vacant units in the building, because that's really what your direct competition is on day one of your investment.”

Beyond merely analyzing the properties themselves, you should also collect details on their existing tenants, as well as their lease expiration dates. (Here, both a CoStar subscription — CoStar is the publisher of LoopNet — and a local brokerage relationship will be useful). This information will offer some insight regarding tenants in the market who you could possibly entice to your property in the future.

In addition to the existing competitive set, it’s important to scrutinize new office properties that are under construction or in the planning stages in the market. Once more (with feeling), CoStar or a local broker can often provide information regarding the supply pipeline. However, in smaller markets — where data can sometimes be hard to obtain and a single additional property can have an acute impact on market dynamics — Brundige recommends paying a visit to the local city hall and reviewing requests for construction permits, variances, etc. to uncover additional development activity.

“What is the municipality doing to attract new businesses or retain existing businesses?”

Jack Brundige

Beyond the supply threats that are already in the construction or planning stages, it’s important to assess the local municipality’s appetite for office construction projects in general. If their approach seems particularly permissive, that “could impact your competitiveness and the rates that you’re going to be able to charge over the five to 10-year hold,” Brundige said.

But that’s not the only aspect of the local municipality that you should consider. Obviously, you’ll want to examine local employment drivers and look for stabilizing factors, such as a tendency for certain types of companies to congregate in that market.

According to Brundige though, “What is even more important to understand is what is the municipality doing to attract new businesses or retain existing businesses? There could be tax credits or tax breaks they’re providing or infrastructure developments.”

With technology-oriented companies becoming one of the primary users of office space in the United States, it’s increasingly pivotal to consider how the municipality is prioritizing those companies’ needs. “Are they committing to putting in a better technology infrastructure, so that more tech-related companies want to be in and around this location versus another?” Brundige asked.

Brundige advocated for reaching out to as many municipal officials as possible, including the town planning and zoning commission. This will help you gain information regarding all of the aforementioned municipal elements, as well as some of the more qualitative features that can help attract or retain businesses. “What are the programs they have in place to improve public parks and streetscapes in the local community that make it a more pleasant place for people to work?” Brundige inquired. He added that “some areas are really being thoughtful and intentional about some of those features and some places aren’t.”

One final element to evaluate that falls under the municipal auspices is taxes. “Traditionally, municipalities have hit office buildings pretty hard based on the money that they've generated, so that's a significant expense, and it's something to be mindful of,” Brundige said. He suggested ascertaining not only what the property’s current tax burden is, but also what the likelihood is that it will increase during your hold period. Because of the complexity of this dimension of the due diligence process, Brundige believes it’s worthwhile to engage the services of a third-party consultant, even for smaller properties.

“They won't charge too much to do it,” Brundige said. “And it will keep you from making a mistake.”

Brundige noted that, over the past decade or so, there have been two profound shifts in the office market that investors should consider as part of their due diligence: the growing prevalence of coworking spaces and the increasing emphasis on the “tenant experience.”

Coworking Spaces
Coworking is obviously not a new concept — its existed in some form for decades — but as Brundige remarked, “Over the last couple of years with the presence of some very large coworking outfits, including WeWork, it’s become a major presence, not only in urban centers, but across the country and in suburban markets as well.”

Brundige clarified that office investors shouldn’t necessarily regard coworking operators as their nemesis, or even their competition. What’s critical is to identify how coworking is being utilized in the local market where your prospective property resides.

“Is it absorbing demand from your main office target market? Or is it an overflow type of situation that is just there when a tenant is flexing up and down in terms of their footprint?” Brundige asked.

Understanding what kinds of users are patronizing local co-working facilities will give you a clearer sense of whether those businesses represent a threat to the property.

In addition, the types of users that your property leases to, or that you hope to attract in the future, will often dictate the extent to which coworking poses a concern. For instance, if your property largely comprises medical offices or large, more established tenants, you’re probably relatively insulated from coworking competition.

The Tenant Experience

“There's been a great shift in the office industry toward service-oriented ways to understand and respond to tenant preferences.”

Jack Brundige

Of course, one other relevant issue with regard to coworking space is whether you may want to add one to your prospective property, which neatly aligns with the next point up for consideration: the tenant experience.

In recent years, “there's been a great shift in the office industry toward service-oriented ways to understand and respond to tenant preferences,” Brundige said. This can include a vast array of features and services – from conference rooms or event spaces that are available to rent, to food courts, yoga studios and coworking options.

“You have to evaluate the building that you’re buying and see what they currently have and [determine] how that speaks to your current tenant base. And, if it doesn't, then consider ways that it could be adjusted,” Brundige noted.

You also need to ascertain what services are specifically guaranteed in any existing lease documentation. In some instances, the current property owner may have promised to provide food services, for example, and in the event that they curtail or eliminate those services, some tenants could be entitled to a reduction in rent or even the ability to cancel their lease entirely. Therefore, you need to be aware of what assurances have been made, and verify that you will be able to meet them going forward.

Brundige recognized that many investors may believe that the experiential office trend doesn’t apply to their building, and is only really relevant to class A properties in large cities. But he felt that view was a bit myopic. “To some degree, it's there, or it’s lurking in the wings, and so, if you are looking to make a five to seven-year investment in the office market, it wouldn't be a good idea to ignore its significance,” he said.

“I think you have to continue to apply the basic fundamentals for an office investment.”

Jack Brundige

Of course, coworking spaces and experiential office features seem almost inconsequential compared to the big question that looms over the office market: how will the past year of remote work, due to the pandemic, impact office footprints in the future?

The short answer? As they say in Hollywood, nobody knows anything.

“The smartest people in the business are considering it,” Brundige said. “And there's a lot of people saying that, on a net basis, the footprint may come down, but it's still not known.”

Nonetheless, Brundige feels that this uncertainty shouldn’t necessarily deter the intrepid office investor. “That's separate and apart from, ‘can you still underwrite an opportunity?’ And I think you have to continue to apply the basic fundamentals for an office investment and look at the risk profile maybe a little bit differently.”

Moreover, Brundige noted that while tenants may contract their footprint in the short term, he “would expect businesses to continue to be growing in terms of their [space] needs” during a longer hold period, as net new jobs are added to the economy. In addition, Brundige felt that the potential for some contraction was in keeping with the longstanding jigsaw puzzle nature of owning an office building. In fact, a tenant relinquishing space could create an opportunity to lease space to a smaller user or enable another tenant at the property to expand.

“That's always been a fundamental aspect of owning an office building, where you don't have widgets — it's not like a one-bed, two-bed, three-bed situation — it’s, ‘hey, you've got a floor with multiple users that have contracting and expanding needs.’ You're always having to deal with that aspect of it.”