Real Estate Watch: Low-Rise Office Market
Low-Rise Space at Cycle Bottom
By GARY STACHE
Along with research and development property, low-rise office space,also known as garden office,is the primary category type most out of favor among investors.
Many investors have pulled out of acquiring class B and class C office space. As a result, some see it as a good time to make a play on an out of favor sector that’s at the bottom of its cycle.
Cap rates for garden office are from 8.5% to 9.5%, depending on quality and submarket.
Garden office offers the greatest spread between cap rates and available interest rates. Buyers can borrow at a 70% loan to value with interest rates 5.75% to 6.25% fixed, amortized over 25 years and due in 10 years. The corresponding cash on cash returns is about 12%.
Many garden office buildings have a number of smaller tenants with less than 2,000 square feet. That limits the risk of a large tenant moving out and the corresponding devastating effect on cash flow.
Typically, buildings with smaller tenants also have much lower tenant improvement rollover costs, in the $3 to $5 per-square-foot range, vs. $10 to $20 per square foot for larger space.
Smaller tenants also are less likely to move for a few cents a foot in savings because of the disruption to their operation and the relatively small amount of dollars involved.
So buildings with smaller tenants tend to provide a much more stable cash flow to investors.
The top submarkets for class B space are Los Alamitos, Santa Ana Civic Center, Town & Country and downtown Anaheim, with an average 8.25% availability rate.
Newport Center, Santa Ana Civic Center, downtown Anaheim and Anaheim Hills are the top submarkets for class C space, with an average availability rate of 2.15%.
It’s critical to understand the spread in lease rates between the class A, B and C space.
During a down market, class B and C tenants tend to move up to higher class buildings. As long as there’s a big spread in lease rates between the classes, it’s less likely that a tenant will jump from one class to another.
The markets that have the greatest spread between class C and class B rental rates are the John Wayne Airport area and Newport Center.
The biggest spread in rates from class B to class A buildings are the Park Center and South Coast Metro submarkets.
That means that in these submarkets there is less of a chance of pulling tenants from lower class buildings.
Above-market yields can be made by the astute investor who does his or her homework.
The key to making money in this market is having a thorough understanding of the dynamics of each submarket.
Stache is a senior vice president with the Private Client Group in the Newport Beach office of CB Richard Ellis.
