5 Years in the Life of an Office Building

5 Years in the Life of an Office Building

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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 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 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 he must 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 to 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 who’s minimum required DSCR is 1.3. Additionally, Louie’s NOI has taken a huge hit due to increased vacancy, and his total return “plummets” from 5.81% to 5.37%. Regardless of the banks 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 are 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 in times of struggle, opportunity exists for the savvy investor.

Written by Calvin Andrews

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N Academy Blvd
Sale Transaction

$10M Luxury House Sale in Denver

Jansen, Kaufman & Groothuis PC leased 1,524 SF of office space at 7901 Southpark Plaza, Suite 201 for 2 years. Jeff Brandon and Matt Kulbe of NavPoint Real Estate Group represented

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NAVPOINT REAL ESTATE

CONFIDENTIALITY / NON-CIRCUMVENTION

NON-DISCLOSURE AGREEMENT

NavPoint Real Estate Group (“Broker“) has been retained as the exclusive Broker regarding the sale of the property located at the address noted below.

To receive an Offering Memorandum (“Offering Memorandum“) please read this Confidentiality Agreement and agree to the terms. The details and information contained within the Offering Memorandum were obtained from sources deemed to be reliable. Verification of the information contained within the Offering Memorandum are the sole responsibility of the Potential Purchaser. No representation is made to the accuracy of the information by Seller or Broker. THIS AGREEMENT is made and entered into by and between NavPoint Real Estate Group and “Potential Purchaser” and shall become effective when executed by Potential Purchaser or Potential Purchasers Broker.

A. Commencing with discussions held between their respective representatives the parties have pursued and expect to continue to pursue discussions (the Discussions) relating to the potential sale of:

In the course of these discussions, Seller has disclosed to Potential Purchaser and may continue to disclose to Potential Purchaser certain information of proprietary and confidential nature (“Confidential Information”).

B. Seller will provide to Potential Purchaser certain printed, typed and handwritten materials and other tangible materials containing or relating to Confidential Information (“Documentation”).

In order to protect the Confidential Information, both during the term of the Discussions and after their expiration or termination, Potential Purchaser agrees as follows:

  1. Potential Purchaser shall maintain the Confidential Information in strictest confidence and shall not disclose to any third party any Confidential Information received from the other party. In addition, Potential Purchaser shall ensure that its officers, employees and agents likewise maintain the Seller’s Confidential Information in strictest confidence and that such persons do not disclose such Confidential Information to any other party. Potential Purchaser shall not have the right to use, duplicate, reproduce, copy, distribute or disseminate Confidential Information except for purpose of the discussions and negotiations as needed.
  2. Potential Purchaser agrees to limit access to Confidential Information received from the Seller to its own officers and employees on the absolute need-to-know basis solely for the purpose of the Discussions, and to use the same degree of care in reserving the secrecy of the Confidential Information furnished by the Seller and/or Broker as it uses in preserving the secrecy of its own Confidential Information.
  3. Notwithstanding the conclusion or termination of the Discussions, Potential Purchaser shall continue to fulfill its obligations hereunder for a period of one (1) year from the date of disclosure. Upon termination of the Discussions, all Confidential Information, including all forms of Documentation shall be returned to the Broker, including any copies or adaptations made by the receiving party.
  4. The obligation of Potential Purchaser under Paragraphs 1 and 2 above shall not apply or shall cease to apply to any information which Potential Purchaser can demonstrate by reasonable documentary proof- (a) to have been in the possession of Potential Purchaser at the time it was first disclosed by the Seller and/or Broker; (b) was in the public domain at the time it was disclosed to Potential Purchaser; (c) entered the public domain through sources independent of Potential Purchaser and through no fault of Potential Purchaser; (d) was lawfully obtained by Potential Purchaser from a third party who is free to disclose such information to Potential Purchaser; (e) to have been at any time developed by Potential Purchaser independently of any disclosure from the Seller; or (f) has been in the possession of Potential Purchaser for more than five (5) years.
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