Leveraged Breakdowns

Sector Series: Office (Part 1)

Executive Summary / “TLDR”

Office is a core sector within commercial real estate and historically has been a popular area for real estate private equity firms to allocate time and capital. The iconic nature of certain office buildings has made office deals especially appealing to many high-profile investors over the years. The performance of office real estate as an investment has been more mixed through the last cycle. Office buildings are very capital intensive, requiring a large chunk of the building operating income to lease and adequately maintain the buildings. Rent growth has been decent over the last cycle, but not as strong as that of less-capital intensive and less-cyclical peers, industrial and multifamily.

In the last several years, the office sector has ceded ground to the industrial sector, which has experienced tailwinds from the rise of e-commerce. Additionally, COVID significantly disrupted the office sector, giving rise to a work-from-home culture that may be somewhat sticky post-pandemic. Other trends that have emerged post-COVID include shorter lease terms, more focus on in-office health amenities, larger dedicated collaboration space, and “hot desks” that can accommodate different employees on different days. The near-term outlook for office demand is somewhat murky, given the still unknown return to office protocol for many organizations as of mid-2021. That said, from an investment standpoint, dislocation typically leads to opportunities for those willing to spend the time to look.

Quick Note: Think of this blog post as part office real estate primer and part office sector update. We cover the basics for those new to real estate private equity, but also dig into the weeds for those looking for something more. Ultimately, we aim to cover the things that really matter for the sector in just a few, easily digestible pages.

Types of Office Buildings

Offices real estate provides space for people to work. This happens in a number of different formats, including high-rise office towers in major central business districts, corporate campuses situated in urban or suburban lower-density areas, or even co-working space, with open floor plans and desks or small offices that can be leased out to individuals or small companies. In terms of classifying office buildings by type, one simple classification is to divide office into two broad categories:

  1. Traditional office space – traditional office space generally has the following traits: a reception area, conference rooms, open-space for rows of desks, private offices, and collaborative space. The types of tenants that occupy traditional office space have historically been financial institutions, law firms, government tenants, or other large enterprises.
  2. Creative office space – creative office space generally has the following traits: high ceilings, open floor plans, large windows, and fewer private offices. This type of office space emphasizes collaboration and transparency. Historically, the types of tenants that have occupied creative office space have included tech companies, startups, marketing firms, and media companies. That said, in recent years more traditional office space tenants, including large financial institutions, have explored this type of space in order to facilitate collaboration as well as compete for talent.

Asset Quality

Most core commercial real estate is classified by quality into Class A, Class B, or Class C quality grades. Below are some of the defining characteristics of those classifications for office real estate:

  1. Class A  — Class A buildings are the highest-quality buildings in the best locations with the greatest amenities. Class A buildings are generally newly-constructed buildings or slightly older vintage but very well maintained assets. They have reputable owners and are located in the heart of the central business districts with easy access to major transportation hubs. In terms of amenities, Class A buildings generally have a large central lobby with a building concierge, high ceilings, and amenities including high-quality restaurants, cafes, and fitness centers located on the ground level. Class A buildings command the highest rents and are generally leased to well-established companies on long-term leases (10 years).
  2. Class B — Class B buildings are usually older properties but are still well maintained, well located, and have functional amenities on-site. They provide a good product for tenants that are seeking more value with solid functionality. Class B buildings generally command the average rent for the market.
  3. Class C — Class C buildings are usually the oldest properties on the market in less desirable locations, farther away from major transportation hubs. They offer fewer amenities, if any at all. Class C buildings are often in need of major repairs or total renovation. They are leased to very budget-conscious tenants at the lowest rents in the market.

Top Office Markets

The top 10 U.S. office markets are listed below, per a JLL report1. Each of these markets has several distinct submarkets which further delineate geographic locale and average rent levels. For example, New York City is broadly divided into Midtown, Midtown South, and Downtown (though it can be further subdivided into smaller submarkets, such as Park Avenue, Grand Central, Far West Side, Flatiron District, etc.).

U.S. Top Ten Office Markets by Square Feet

Market Million Square Feet
New York 456
Washington DC 341
Chicago 254
Dallas 193
Los Angeles 189
Houston 173
Boston 170
New Jersey 158
Atlanta 151
Philadelphia 139
Source: JLL U.S. Office Outlook – Q1 2021

Office Leasing 101

Office leases are generally on the longer-end for commercial real estate, typically 5-10+ years. This is a long commitment period for less well-established firms, and is partially responsible for the more recent rise of coworking and flex office space. Office leases are generally structured as Gross Leases, due to the multi-tenant nature of office buildings. This means that tenants pay a rental rate that includes pass-throughs for building expenses. Leases are often also structured with a Base Year and an Expense Stop. This means that in year 1 of the lease tenants pay a base rent, and in year 2 of the lease pay that base rent plus a pro-rata portion of the increase in the building’s operating expenses over the base year. This is due to the high cost structure of office buildings, and effectively allows landlords to pass-through any increase in operating expenses pro-rata across the building’s tenants. For more detail on lease types, please see our post on leasing fundamentals.

Another important concept in office leasing is Net Effective Rent. Net effective rent accounts for various landlord concessions, including Tenant Improvement (TI) Allowances, Leasing Commissions, and Free Rent Periods. A TI Allowance is a dollar amount that the landlord pays to the tenant upon signing a lease that covers the tenant’s costs to build-out their space. Leasing commissions are expenses that the landlord pays to a leasing broker in exchange for finding a tenant. Lastly, a free rent period is a period at the beginning of the lease term where the tenant doesn’t pay any rent. All of these expenses are borne by the landlord, effectively reducing the gross amount of rent received. In order to calculate net effective rent, one simply takes the gross rent over the lease term and reduces it by the monetary value of these concessions, and then divides the resulting number by the lease term (to arrive at an annual net effective rent).

Capital Expenditures

Capital expenditures or “capex” is another defining feature of the office sector. In the last several years, attracting office tenants has become a more competitive proposition for a couple of reasons, 1) tenants have been more willing to upgrade their office space in an “arms race” to attract talent to their companies and 2) the rise of coworking or flex office has presented a viable alternative to traditional office leases for certain organizations. Thus, bargaining power has slowly shifted towards tenants vs. landlords, resulting in steadily rising capex.

Capex is defined as money required to maintain, repair, or lease an asset. Office capex includes the following items:

  1. Tenant improvements (TIs): money paid by the landlord to a new tenant upon lease signing that covers the tenants’ costs to build-out their space.
  2. Leasing commissions (LCs): money paid by the landlord to a leasing broker in exchange for finding a tenant.
  3. Building maintenance expenses: includes regular ongoing maintenance, one-time replacement of certain features or equipment, and major renovations.

The first two components above (TIs and LCs) represent roughly two-thirds of total office capex, with maintenance expenses representing the balance. In total, office capex is a big percentage of the net operating income (NOI), often 30% of NOI or higher, depending on the age of the building. This is a much higher percentage of NOI than that of other core sectors, including industrial and multifamily, which are closer to 15% of NOI. This means that with office, there is an even greater focus on understanding the building net cash flow, which factors in capex.

To be continued in Office (Part 2)…

Given that the office sector has a lot of ground to cover, we broke this post into two parts. In the second part, we’ll review the various ways in which the office sector has been impacted by COVID, provide an overview of the fundamental demand drivers for the sector, and conclude with our outlook for the sector.

Looking to learn more? Why not check out our educational resources! Whether you’re yet to begin a formal real estate private equity interview process or are crunching through real estate private equity interview questions at the last minute, we have what you need. All you need to bring is your effort.

  1. https://www.us.jll.com/en/trends-and-insights/research/office-market-statistics-trends

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