In times of danger, the market rewards those who only choose the best locations. There is a flight to quality for lenders, and since virtually all office buyers use debt than you need to follow their lead. Real estate is all about “location, location, location” and if the office building is not in a strong one, you are probably better off passing on it. The only way you will fill a lesser location is with reduced rent, and that puts you in a tough position when Class A rents ease. It also means that you will be perpetually lowering rents as the condition and desirability of your property wanes.
The income your office property derives is net of repair, maintenance and capital expenditure. Don’t buy properties in poor condition as they will eat up much of your profits and scare away most future buyers and lenders. The problem with office buildings is that they typically require very massive roofs and other issues, and a poorly built property can be a financial drain on a continual basis. Also stick with more timeless designs that are lower maintenance, such as masonry, metal and glass, and move away from a lot of wood and stucco that require endless maintenance and do not wear well.
Credit quality of tenants
A long-term lease with a sketchy tenant is not really that marketable. Stick with properties that have A-grade occupants that will pay rent in both good times and bad. That does not mean that you need flashy law firms – you simply need tenants that have a track record of paying. What they do is immaterial, all that matters is that they have a proven ability to pay rent on time. In light of the Covid-19 strain on American business, it’s definitely not a time to rely on marginal tenants paying you so you can pay your mortgage.
As with any sector of real estate, timing is essential. You always want to buy low and sell high, and not vice versa. Never buy during a cyclical high in that market, but only when prices are at a stable base. How will you know? Looks towards cap rates. A good cap rate for an office property might be 7% traditionally in one market, so don’t buy when it’s less than that. Remember that all it would take to derail your investment profit is for a market to have a correction of 20% or so, thus making you raise value 20% just to get your money back.
And speaking of cap rates, you also need to stay on the right side of the “spread” on your deal. The “spread” is the difference between the cap rate and interest rate on your loan (assuming about 80% LTV). A 3-point spread yields around a 20% cash-on-cash return, while a 2-point spread returns about 15% and a 1-point spread yields around 10%. In general, try to get at least 2-points of spread to maintain a safe cushion against any problems (such as unexpected vacancy).
While it is possible to still make money in office properties, it’s essential that you chart a course that is safe and has all megatrends working in your favor. This list will get you started.