How To Conduct Due Diligence on an Office Property, Part 1
Creating a Stacking Plan, Evaluating Leases, Assessing Tenants and Other Elements
For a novice, and sometimes even for a relatively experienced investor, conducting due diligence on an office property can be an intimidating prospect. Office properties are akin to a three-dimensional puzzle where the pieces are constantly changing in size. Varying lease expiration dates; floors demised in radically different ways; one tenant looking to grow, another planning to contract, while a third plans to relocate — without a clarion approach, it can seem overwhelming.
But while the office due diligence process may require more strategic planning than other asset types, it’s still a highly manageable task — particularly if you have an expert to help guide you through the experience. That’s why LoopNet had an extensive conversation with Jack Brundige, chief of portfolio management with Waypoint Real Estate Investments. Brundige previously acted as our sage escort through the multifamily due diligence process. And while his present position is focused on that asset type, he spent much of his career working in the office sector, where he’s been involved in the acquisition of more than 24 million square feet of properties across the United States, totaling in excess of $12.5 billion.
Based on our conversations with Brundige, LoopNet identified the following top 10 facets of the office due diligence process:
- Conduct a desktop analysis.
- Perform a field evaluation of the site.
- Review leases and create a stacking plan.
- Assess any existing tenants.
- Understand the target tenant market and establish broker relationships.
- Develop underwriting.
- Investigate the competitive set.
- Assess the municipality.
- Consider the impact of coworking and the tenant experience.
- Evaluate the COVID-19 factor.
Over the course of two articles, we’ll tackle each of these topics. We’ll be counting down hits one through five in this piece, while six through 10 will be the subject of part two of this series.
Before we get started, though, a quick word of wisdom from our chaperone. “You have to have some intention to your strategy. You have to have made an assessment of what's there today, what the type of tenants are that you're trying to attract and have an intentional plan on your way in — and not after you buy, because it just opens you up to risk,” Brundige said.
And due diligence, as we know, is all about the process of minimizing risk. So, let’s take this one step at a time.
Conduct a Desktop Analysis
Here’s the good news: the first part of this process, which Brundige refers to as “the desktop analysis,” can be conducted remotely from the comfort of your living room, office or whatever space your laptop calls home. During this phase, you’re going to want to start digging into any available data you can find about the property you’re considering purchasing, as well as the market in which is resides.
Some of the big-picture market and submarket data points you’ll want to evaluate for an office property investment include:
- Office vacancy rate.
- Office absorption rate (i.e., the amount of space leased/vacated over a specific period of time).
- Construction pipeline of new properties.
- Average office rental rate (make sure to focus on the rental rate for the property class — A, B, C, etc. — that aligns with your prospective purchase).
- General economic trends in the market, such as employment rates, including the major employers that are based there.
In addition to gauging the official vacancy rate, Brundige advised that it’s important to consider sublease space that’s on the market — both those units that are officially available, as well as what’s referred to as “shadow sublease space,” i.e., spaces that are not being publicly marketed but are still available for sublease. Brundige warned that, “you may have much more supply out there than you thought you did if you just looked at the pure vacancy rate.” In order to obtain information about those shadow spaces, though, you’ll probably need to connect with a local brokerage professional — more on that shortly.
According to Brundige, you’ll also want to assess the property’s existing operating expenses. Perhaps even more importantly, you’ll want to understand what costs you’ll be incurring when you need to retenant space. What is the average tenant improve allowance in the market? And what concessions, including free rent, are standard? Brundige admitted that those factors can “shift, depending on what's going on in the market, but you can usually get a sense of those trends.”
Brundige garners the majority of this information by evaluating third-party reports. He advised that CoStar market reports (CoStar Group is the publisher of LoopNet) are particularly helpful in this regard. In addition, depending on the market, many commercial real estate brokerage companies produce reports that are publicly available.
Brundige felt that there are no fixed metric thresholds for items such as the vacancy rate at a property; instead, each property needs to be considered relative to its market. “Different markets have different trends,” he said. “The New York City market usually has a trending average of a vacancy rate that’s less than 10%. Other markets have more of a stabilized vacancy rate that's north of 10%.”
What you really want to be mindful of is volatility. “Is that [vacancy rate] moving around a lot? If it's moving around, it might mean that your pricing is moving around too,” Brundige said. This is why it’s critical to consider both current and historic metrics while conducting the desktop analysis.
Perform a Field Evaluation of the Site
“Unfortunately, I don't think there's anything you can't look at. It just starts from the outside and it goes all the way into the infrastructure.”
Jack Brundige, chief of portfolio management, Waypoint Real Estate Investments
“On the basis of that desktop analysis, if it all pencils out that you think that this is something that's worth your time and energy, it's time to jump into the field and really evaluate [the property] with your own eyes,” Brundige said.
According to Brundige, this stage of the process is both meticulous and exhaustive. “Unfortunately, I don't think there's anything you can't look at. It just starts from the outside and it goes all the way into the infrastructure of your conduit systems.”
Some of the items to analyze when performing a physical evaluation of an office property include:
- HVAC systems: Are they modern and efficient, or is “a replacement warranted to keep up with current trends? That can be a very significant cost, so it's important to make sure to evaluate that closely,” Brundige said. This is particularly true in the COVID-19 era, when tenants are more focused than ever on air circulation and quality.
- Technology: Are you providing a system that your tenants can easily connect to and does it offer the bandwidth that they require for their internet and other capabilities?
- Façade and roof: “I've seen a number of aesthetically pleasing buildings that had massive leaks on the façade,” Brundige said. Accordingly, you’ll want to evaluate both the façade and the roof to make sure they are waterproof. A roof replacement on an office property is a notably expensive endeavor.
- Phase I environmental assessment: Request or review this report to make sure there are no relevant issues.
- Fire suppression systems: Verify that these systems are up to code and in good working order.
- Water and lighting: Both water and lighting systems should ideally be relatively modern and efficient.
- Parking and transportation: For suburban properties, it’s important to assess parking ratios, as well as the general condition of any garage facilities. In urban settings, you’ll want to focus on access to public transportation. In both instances, it’s key to consider how a tenant enters the building from either the garage or public transportation. What is that initial encounter with the property like?
A Day in the Life
That last question ties into another crucial aspect of the in-person tour: understanding what it’s like to be a tenant at the property.
Brundige advocated that prospective investors should walk the property like one of its tenants, and carefully consider each step along that tenant’s path, as they make their way from the garage or exterior of the property to their office space. You’ll want to be mindful of what the lobby experience is like, both aesthetically, as well as in terms of security. Is the process of entering the property efficient? Similarly, you’ll need to consider the elevator systems from both an engineering perspective, as well as in terms of their general appearance. Stairwells also should be assessed to make sure they are in good repair, well-lit and reasonably attractive.
Then there are the common corridors on each floor of the property. “Everybody talks about the footprint that a tenant actually leases,” Brundige said. “But they spend a lot of time going back and forth into their space. What do the corridors look like?”
Common area bathrooms are also critical. “Have they actually been upgraded in the last couple of years, or is it something that you might have seen in the 1980s?” Brundige posed. While their individual office space is important, these features of the property create an overall impression for tenants, and “they're going to value the space based on some of those common areas.”
Once you get into the actual office suites, Brundige noted that key items to consider center around how recently the units have been renovated to reflect current office design trends. “You want to understand how much of the building has been renovated with more glass partitions versus drywall partitions,” he said. You will also want to gauge if there’s an opportunity to elevate the ceiling heights. Both these elements create a more open, light-filled space, which modern office tenants tend to prefer.
Review Leases and Create a Stacking Plan
“It doesn't need to be the prettiest thing.”
Your next step is analyzing in-place leases at the property. In addition to evaluating rental rates and expiration dates, you should also pay close attention to clauses within each lease that grant certain rights to tenants, such as expansion, contraction, termination and renewal options.
Then take the intelligence that you’ve gleaned from studying those leases and translate that data into a stacking plan. A stacking plan is a visual representation of the property and all of the occupied and vacant units within it. It shows each floor in the building and should be color-coded to highlight when leases for each space are scheduled to expire, i.e., purple for leases expiring in 2025, orange for leases that end in 2027, etc.
This will enable you to visualize every space at the property, and will serve as an invaluable aid in strategizing how to “contend with expiring leases, as well as potentially relocate existing tenants within the property in advance of their lease expirations to accommodate their needs to expand, contract or move into a space that is built-out differently,” Brundige said.
This is where that jigsaw puzzle metaphor comes into play. The office investor needs to develop a strategy that will enable him to renew as many existing tenants as possible, as it’s virtually always financially prudent to do so, while managing those tenants’ shifting space requirements.
Building a stacking plan will assist with the process of creating that game plan by helping you visualize and fully appreciate upcoming opportunities and threats to occupancy at the property, as well as the potential to drive revenue and minimize expenses and income lost due to vacancies.
While there are programs specifically designed to assist you in fashioning a stacking plan, a simple version can be rendered in Microsoft Excel and similar programs. “It doesn't need to be the prettiest thing,” Brundige advised. “But you want it to be helpful from a visual perspective.”
Assess Any Existing Tenants
Another element informing your strategy, if the building is occupied, will be an assessment of the property’s existing tenant base. Once you’ve progressed further into the due diligence process, generally after you’ve signed a letter of intent (LOI) to purchase the property, you’ll be given access to any financial information that the current owner has about the current tenants. While this data is unlikely to be robust, you’ll also be given data pertaining to the credit that supports each lease and have the opportunity to interview representatives from most, if not all, of the tenants at the property.
In terms of credit, in some instances there will be a cash security deposit, while other tenants’ leases may be secured by a personal guarantee or by a letter of credit from a financial institution that is renewed on an annual basis. Public companies with high ratings from independent credit agencies, or U.S. government tenants, are nearly always preferred.
Higher credit ratings and personal guarantees minimize the risk of defaults and terminations and enhance your ability to obtain good financing terms on the transaction, Brundige explained.
During the interview phase, you can try to discern if each tenant’s business is generally healthy and viable and what their plans are for their space. Understanding whether “they're growing, contracting or have some desire to rethink the way they're going to use space,” will inform your leasing strategy for the property and help you understand “how to maximize the opportunity and offer them what they may be looking for well in advance of their lease expiring,” Brundige said.
Understand the Target Tenant Market and Establish Broker Relationships
“That's invaluable information to help you understand what your opportunity is.”
In order to gain information about potential tenant prospects that are in the local market and develop an understanding of your prospective property’s target tenant base, Brundige recommends partnering with a local landlord broker.
Establishing these relationships early on will help you ascertain which tenants are “in the market currently, and when key target tenants have leases expiring, as these near-term prospects represent a very large part of your target audience,” Brundige said. In fact, as referenced earlier, it’s advisable to begin cultivating these associations during the desktop analysis phase, as local brokers will be able to provide additional details and nuanced insight regarding local market conditions.
Brundige added that local brokers “usually have done a great deal of homework about where people are, when their leases are rolling, how much space they might need — that's invaluable information to help you understand what your opportunity is to attract other tenants to your building.”
In addition to helping you perceive the opportunity and formulate your strategy for the property, developing this critical relationship at the outset, before you’ve finalized your acquisition, will be beneficial when vacancies arise in the future. Brundige noted that those brokers will then be particularly motivated “to really compress the timeframe that you have space that’s vacant and make sure that you're getting good visibility on what the market concessions are that you're competing with.” This will ensure that you’re completing a “deal that is competitive with the market.”
In part two of this series, we’ll consider the remaining phases in our top 10: develop underwriting; investigate the competitive set; assess the municipality; consider the impact of coworking and the tenant experience; and evaluate the COVID-19 factor.