SPOTLIGHT ARTICLE  from Loop Net, 2007

Office Space Investing

There’s one real estate veteran out there who has enjoyed quite a bit of success over the years in virtually every kind of market imaginable, and he has a knack for condensing years of experience into easily digestible sound bites. Those who are looking to invest in commercial properties that can be used for office space or small businesses will likely find little fault with some of this fellow’s latest nuggets. For example:

• Make sure you create sizzle, glamour and prestige with whatever property you’re investing in;
• Accept guidance from only the best real estate and investment specialists you can find;
• Give your potential tenants the best perceived value imaginable for whatever it is they’ll be renting.

True enough. Who can argue with that? The properties in which you are interested should flash dollar signs not only in your eyes as the investor, but also in the eyes of those who will eventually occupy those spaces. Furthermore, the professionals you are working with to make it all happen should know how to avoid any pitfalls that sneak up along the way. Only then will you come out of the experience with a newfound respect for tycoons like the one who offered those little sound bites in the first place.

His name happens to be Donald Trump.

The problem is, of course, that by definition, sound bites do not go into details, and much of real estate is in the details, from investments analyses and downtown renewals, to security deposits and tax implications — and a thousand other variables in between that can and will affect any venture into the business. (In Mr. Trump’s defense—not that he needs defending—he has authored several books on the subject that flesh out many of those details.)

Nothing Ventured, Nothing Gained

Very few brokers, lenders and other professionals involved in real estate will recommend that new investors start out in the commercial end, even if it’s for a modest undertaking like a small office building. There are several reasons for that, many having to do with vacancy and rental rates in that particular market, which tend to be somewhat erratic. On the other hand, many veterans and observers will eagerly repeat that old chestnut: nothing ventured, nothing gained.

“People are indeed purchasing commercial office space as an investment, but not nearly as much as other asset classes, such as multifamily properties and strip centers,” said Michael Brewer, vice president of Carteret Commercial Mortgage, a nationwide firm headquartered in Fredericksburg, VA. “Typically, the down payment requirements for these types of investments start at 20 percent and go up, depending on the quality of the deal.”

While any real estate investment has challenges that range from the up-front financials to the back-end returns, the office space and small business market sometimes falls into gray areas in which the experiences of others may bear little resemblance to the experiences that are in store for you.

“More people used to do this, but less nowadays because property values make it difficult to make business sense of an acquisition,” concurred Joseph De Sane, vice president of the Bridgehampton, NY, office of The Corcoran Group, a major real estate firm with branches throughout Long Island, Manhattan and in South Florida. “Those who want to give it a try, particularly for the first time, should work out a business plan that is capable of a 10 percent return on the investment per year—at the very least.”

It’s certainly possible—but not always.

The Attraction

Still, there are several attractions for both the newcomer and the old-timer to go into commercial real estate. For one thing, in the right market the rents can be lucrative. Also, in the commercial world tenants tend to be somewhat more responsible for the maintenance of their rented spaces than many residential tenants.

But perhaps one of the biggest inducements is the fact that you can use some of the new space for your very own — such as a small office that can accommodate your growing real estate investment business. (Many an empire has begun modestly that way.)

Fortunately, commercial real estate often presents opportunities to do much more accurate analyses of the market than other kinds of investments, and that can help determine whether or not it is a good time to get into it. Unfortunately, the Newtonian-like laws of real estate dictate that for every potential draw there is a potential snag. But with eyes wide open and a skilled support team just a cell phone call away, many of those snags can be avoided. You just have to be prepared for them.

First of all, commercial real estate is always more difficult to finance. It often takes more time than many people are willing to spend to find suitable tenants, which means that you will have to pay taxes and insurance until the space is occupied.

Secondly, when tenants move out, new tenants very frequently require changes, customizations and improvements that can be costly — and as the owner you may wish to agree to cover those expenses (even if you’re not legally obligated to ) just for the luxury of staying competitive.

Pitfalls can also occur when an investor does not put in a long enough review or settlement period into the contract. In commercial real estate, patience is as important as security.

“The ability to think ahead is also a virtue,” added De Sane. “Imagine how frustrated you’d be if you go through all the twists and turns of buying a property for commercial office space only to find out at the last minute that it is not zoned for that use.”

In other words, do your homework first.

Commercial Space Growing

Despite challenges, setbacks and the occasional nightmare, the market seems encouraging; apparently enough people are doing their homework first because there are many indications that office space investment may be one of the hotter markets in the months and years to come.

“The office sector will clock substantial expansion in 2006 where vacancy levels are expected to decrease while rents are poised to increase,” said Ross Moore, senior vice president of Colliers International, the global real estate services firm based in Boston, which recently conducted its annual Commercial Real Estate Forecast.

Similarly, the National Association of Realtors (NAR), in its own Commercial Real Estate Outlook, concluded that the need for office space seems high by virtue of the fact that vacancy rates are expected to drop to an average of 12.7 percent in the fourth quarter of 2006 (down from 13.6 percent during the same period last year). At the same time, office rents will rise 4.4 percent.

“Commercial real estate remains a bright spot in the economy, but there are concerns over energy costs, rising interest rates and slower-than-expected job growth, which could dampen future demand,” explained NAR’s David Lereah, chief economist. “With tightening vacancies and a slowdown in speculative construction, the office market will offer respectable returns for investors.”

According to the NAR, areas with the lowest office vacancy rate today include Ventura County, CA; New York City; Orange County, CA; Fort Lauderdale; Riverside, CA; and Washington, D.C. The top markets for office investment over the last year were Manhattan, Chicago, Los Angeles, San Francisco, Northern Virginia and Washington, D.C.

But a national study like that cannot possibly take into account the trends, benefits and liabilities of investing in commercial office space in smaller towns and villages all over the county. Indeed, almost every fairly active Main Street commercial district has a property or two in which an investor may be interested to look for office space or small business properties. In fact, some experts recommend finding out where ‘downtown revitalizations’ are taking place. The existence of Special Improvement Districts, or SIDs, is often a key indicator. These areas are frequently prime suspects for office space investment; sometimes it comes with the opportunity to invest in a building that has offices upstairs and retail space for small shops and services on street level. As far as office space is concerned, the proximity of shops, services, restaurants, parks and other municipal attractions can provide at least some of the sizzle, glamour and value that Mr. Trump was talking about.

“If I were to get into this area of the market right now, I’d definitely look for areas where there are signs of future commercial activity — such as new housing developments going up where once there were nothing but farms and fields,” said Brent Zimmerman, a broker with the Prudential Group in Southern California and an individual investor who carefully monitors all the trends. “Obviously, commercial development, including the need for office space, is going to follow residential development. Many new residents are going to be looking to start their own businesses or open their own practices of one kind or another.”

One way to learn about commercial and office space investment is to note how it may differ from residential, industrial or speculative investments. Much of the distinction goes to the kinds of lease agreements you will use with your tenants.

Primarily, you will rent your office space for a specific dollar amount per square foot of space. The leases you use will often resemble loan documents rather than rental agreements. (Lenders often rely on these documents to collateralize loans.) You might use a net lease with which tenants pay a portion of the building’s maintenance. If residential investing is the only real estate activity in which you’ve been involved, you may very well learn about entirely new kinds of leases as you go forward, such as triple net leases (where the tenant pays for maintenance, insurance and property taxes), or gross leases, where the owner is responsible for energy cost increases. Office building leases can also be simple month to month rentals.

Do Your Homework

Without a doubt, advice is plentiful but it never takes the place of personalized research geared to the specific city, town or village in which you’re interested. Partnering with knowledgeable real estate professionals, mortgage brokers and investment counselors is also important, as is listening to the stories of those who have already been there and done that. Some of the stories are priceless. Like the one about the owner of a two-story office building in New Jersey who rented out space to a holistic health company only to discover (after the police raided the place) that it was actually used as an illegal massage parlor.

It’s worth repeating: do your homework first.

Obviously, questions must be asked, research conducted, situations assessed and tools acquired before any commercial or office space investment can be transacted.

For example, before signing on the dotted line ask yourself:

• Is there ample parking for my tenants’ needs?
• Is this a safe community?
• Is this building structurally sound?
• What are the local laws and ordinances concerning handicap parking and accessibility, and how does this building fit those requirements?
• Did I analyze the property and all related documents well enough?
• Did I check to see if there are any hidden costs with the brokers, agents or consultants with whom I am working?
• With regard to my loan, am I getting the best type for my needs? (There are several kinds of loans, including SBA 504 loans, adjustable commercial mortgage loans, hard money loans, sale-leaseback agreements and more; all have different terms, gains and risks.)
• Did I request the business financials of the tenants I already have lined up to take possession of my office space so that I can be assured of solvent tenants? (This can help avoid having tenants who, in turn, invite nervous-looking men to go in and out of their office at regular intervals.)

If you are new to the market, the region or to investing in general and want to take a good look around before you leap, you should:

• Stay in touch with local business community, chambers of commerce, city councils and planning boards to find out the local trends, needs, ordinances and potential investment hazards.
• Avoid areas where the supply of available space has increased faster than the demand for it, or where vacancies occur frequently and rental rates fall quickly. (This is called negative absorption.)
• Become accustomed to leaving plenty of time for all the proper appraisals and inspections to be conducted. As frustrated as investors often are in purchasing homes, commercial investors can be equally or even more frustrated at some of the methods and madness associated with commercial real estate.

No one ever said it was easy. Not even Donald Trump. But it can certainly be accomplished, and the results can be advantageous. To be sure, the benefits are not necessarily just financial gain for you, but economic gain for the community at large. Prime, attractive, useful, relatively affordable office space can help provide business opportunities (and jobs) for many people. That, in turn, brings in more revenue to the town, which can translate into municipal improvements and a better quality of life for everyone. That’s the kind of thing that can provide enough personal sizzle to make you feel like a real VIP — even if you haven’t written your own book yet.

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