I originally posted a similar article in 2021 when interest rates were under 4%. Developments have been completed and others have started. On the commercial side, the State of California has completed several office buildings just south of the Capitol. Also, nearly 1000 residential units have come online in the Core, with more on the way. Bay Area migration has been driving the housing market, but over the last two years, the demand for office space has plummeted. Through April of 2022, Owner user sales were brisk and it seemed as if the roll would continue for several years. Oh, what a difference a year – and three or four percentage points – makes.
But if you are an office user thinking about buying an office building, don’t forget the fundamentals. Sales of Owner-User buildings were driven by historically low-interest rates, and values were pushed up by low supply, rising construction costs, and increased rents. But now demand is off significantly and the higher interest rates and the buy vs. lease analysis will most likely support leasing – unless the property is priced right, and the building is an ideal fit for the buyer. The good news for buyers is that prices are starting to come down and if the price of a particular property has not been reduced to reflect the current market the property owner might end up following the market down.
The silver lining for the buyer is this: The price of the property is more in line with its intrinsic value, not a value propped up by low interest rates. So, let’s say that you are looking at a building to buy. I recommend that you consider the following:
- What is the exit strategy? If for some reason you need to move out of the building, will you hold the asset and lease it out, or will you sell it? Is the property single purpose or will it appeal to a broad base of potential occupants and buyers?
- What is the replacement cost? What would it cost to build the building from the ground up versus what are you going to be into the property for after purchase and renovation? You can get into a property, for what seems like a great buy, but after you finish renovating the building for your needs, your total cost could exceed replacement cost. That is ok if the property works for you, and in the long run, the market supports the investment (based on projected value appreciation.)
- What is the Property worth as a leased investment? Just because you are an owner-occupant does not mean that you should pay an over-market price for real estate. Certainly, as an owner-occupant, you can justify paying more than what an investor would pay, but be sure to consider what an investor would pay if the building was valued as a leased investment (at market rents.)
- Is there upside beyond market appreciation? Consider a small building that sits on a large lot. Perhaps ten years down the road you can sell the site to a developer, or you can develop it yourself. Many properties have a mid-term use and a long-term use. Consider a 4,000 SF office building on a 12,800 SF parcel in midtown. BCRE sold a property just like this in 2021. The building was a perfect owner-user building, and if and when the new owner decides to move on and sell the property, a likely buyer could be a developer looking to maximize the site’s value.
There are many benefits to owning, but don’t get caught up with the emotional side of things. Consider the fundamentals, and if the price seems like a stretch, you might be better off as a tenant. Let an owner take care of maintenance, taxes, capital improvements, and assorted management headaches. You can focus your energies on building your business.
Tom Bacon, CCIM, has been assisting commercial real estate clients in Sacramento since 1991, with an emphasis in office properties and Occupier representation.