5 Years in the Life of an Office Building: 2018-2023
navpoint / February 14, 2023
This has been a rough couple of years for Office Buildings. To understand the state of the office market in 2023, we will analyze a hypothetical Office building that we believe is descriptive of the Office market. Louis James Costello buys an office building in the Denver market in 2018. Denver is growing, and Louie is excited about this new opportunity. He buys the 50,000 SF building at 75% LTV with a market interest rate (at the time) of 3.5%. It’s a 25-year amortization with a 5-year term, and Louie believes that rates won’t move considerably in the coming 5 years. His prospects of refinancing at a similar or even better rate at loan maturity appear favorable. A multi-tenant facility, Louie’s vacancy rate at the time of acquisition was comparable to market vacancy rates at the time of 10% and his NOI is roughly $700K or $16.00/SF NNN. His debt service coverage ratio at the time of acquisition is 1.49. Louie is confident that he can increase rents by 2% each year and eagerly awaits the years of yield growth ahead of him.
Fast forward to 2023. It is time for Louie to pay the bank, refinance, or sell his building. The market looks a bit different than Louie had anticipated when he took his loan in 2018. Interest rates and inflation have soared, vacancy rates have spiked, and market rents, while higher than in 2018, have not grown nearly enough to combat the tight market conditions. See the graph below for the full picture of the market in the last 5 years.
Let’s look at Louie’s options for handling his impending balloon payment on his loan. Here is a quick summary of the options that Louie needs to evaluate before making his decision:
Louie owes $6.5 million in 2023. Unless Louie has wealthy grandparents who have recently passed on to their great reward, he has two options: he must sell his building and pay his loan or refinance.
In the event of a sale, Louie’s equity multiplier on his original investment would be 1.19. This assumes an end-of-year sale with all proceeds before debt totaling $9,893,614. After paying his debt service and his balloon payment, he would be left with $2,969,023. Not bad for an original equity stake of $2.5M, especially considering he collected roughly $275k after debt coverage each year in the interim.
Now let us consider what it would look like for Louie to refinance. Market vacancies have gone way up, and Louie must now deal with nearly 15% of his building being vacant. Despite 5 years of increasing rent, he recognizes a decrease in his original Net Operating Income due to the increased vacancy rates. To make matters worse, his new interest rate has increased drastically. Louie will be lucky to secure a loan at 7.5%, and this is assuming he can maintain the same DSCR that the bank was used to seeing from Louie, 1.61. As shown in the graphic above, Louie will decrease his monthly payment with a new loan, but at the cost of increasing his capital investment by $1.8 million.
To attain this DSCR Louie will need to increase his equity stake in the building to $5,314,177. This is a 52.96% increase in his equity stake! This would make his Leveraged IRR at the end of 10 years 5.81%. This dismal return is only possible if Louie has an extra $1.8M to dump into the deal. This route doesn’t pencil.
If Louie can secure a loan without adding capital, his DSCR will be closer to 1.18. This is very low and represents a huge risk for the bank whose minimum required DSCR is 1.3. Louie’s NOI has also taken a huge hit due to increased vacancy, and his total return “plummets” from 5.81% to 5.37%. Regardless of the bank’s willingness to extend a loan, this course of action doesn’t work for Louie.
Considering each of the above situations, the only solution for Louie is to sell his building. This is also slightly problematic, as Louie is officially desperate. Any potential buyer who has done his research will know that Louie can’t afford to keep his building, and they will be in the driver’s seat in a price negotiation. If he were to sell his building at an 8 CAP, he would only be able to sell for $8.5 million. Louie must consider selling his building at a net loss to shelter as much of his original capital investment as possible. Even if he losses $500K of his original equity, Louie should sell his building and avoid hemorrhaging more capital into a dead deal.
Something that was not considered in the scope of this analysis is Tenant Improvements. Landlords cannot hold buildings for 10 years and expect their rent to increase at a constant rate without regular improvements to both the exterior and interior of the building. These TIs would be significant in year 5 most commonly, which adds another layer of desperation to poor Louis James Costello’s situation. The market will be ripe with buildings just like Louie’s as loan terms run out and building owners are forced to make hard decisions. 2023 could be a rough year for building owners like Louie, but opportunity exists for the savvy investor in times of struggle.
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