If you’re thinking about purchasing commercial real estate as an investment, office buildings can be an exciting prospect. Potential investments range from small single tenant buildings to the downtown high-rises that define a city’s skyline. For those new to the arena, it can be a complicated endeavor full of strange new terms. With some research and a little perseverance, however, you’ll soon find yourself fluent in the language of office real estate and ready to make your first deal.

Know Your ABC’s

Office buildings are categorized in three different groups: Class A, B and C.

Buildings are given a Class A designation if the design and finish are of the highest quality, they attract quality tenants and are professionally managed. Class A buildings have superior locations and command rents at the top of the market. Think of the new glass and marble building in a financial district, occupied by lawyers, stock brokers and other high end tenants all desiring the trappings of success — that is a Class A building.

Class B buildings have rental rates considerably lower than Class A buildings. While they are well maintained and have a good quality design and finish, Class B buildings may be located in less expensive office parks or suburban areas. Class B buildings are often older Class A buildings.

Class C buildings tend to be more utilitarian than aesthetic. They are often more than 20 years old, but still have steady occupancy. Many are located in mixed use buildings, often on the upper floors above retail or service businesses, or in industrial parks. Class C space rents for less than Class B space, typically in the lower 20 percent of a given market.

It is important to note, however, that while these buildings need to meet more than one requirement to be categorized within a building class, there is no specific formula and there may be a judgment call required in a final analysis.

Valuation and Cash Flow

Office buildings are valued to a great degree as a function of their income – ultimately the tenancies and leases that are in place – while residential real estate is not. A residential duplex or single family home is typically appraised at or close to the same value whether it is vacant or tenanted. This is not the case for office buildings. A fully tenanted building boasting long-term leases and national tenants will be valued considerably higher in the market place than an empty one. Commercial appraisals use a combination of three methodologies to value a building: the cost approach, the sales approach and the income approach.

With the cost approach, appraisers calculate how much it would cost to rebuild the structure from scratch, including the purchase of the underlying land. Appraisers typically assign more weight to this approach for buildings less than five years old or if they are highly specialized, such as medical offices.

The second method is the sales approach. This is analogous to the “comps” that realtors use when setting residential home prices. Appraisers conduct extensive research, looking at similar buildings in the market and comparing square footage, location and a host of other factors before calculating an estimated sales price that could be achieved for the subject property if it was listed for sale.

The third approach, and perhaps the most useful method for office investors conducting due diligence, is the income approach. This value is based on the net income a building owner makes on the spaces that are leased (you will also be able to estimate your cash flow with this model as well). The appraiser takes monthly rent payments from the rent roll (a document listing all of tenants and information about their leases) adds them together and calculates the buildings gross income. Net operating income (NOI) is then determined by subtracting the expenses from the gross income. With that information in hand, it is back to the market to research what capitalization rates are for similar buildings. A capitalization rate, or “cap rate”, is a ratio of net income and capital cost. It is calculated by taking the NOI for the building and dividing by the purchase price. For example, a building purchased for $1 million that generates $100,000 in net operating income has a cap rate of 10 percent.

$100,000 / $1 million = 10% cap rate

When valuing properties it is useful to think of the cap rate the same way you would look at a rate of return for any other investment. The higher the cap rate, the higher the rate of return on the investment, but also the higher the perceived risk. Cap rates vary depending on the location, size and history of the property and will be lower for Class A buildings than it will be for more risky Class C ones. Once a cap rate is determined, it is divided by the NOI to determine the value of the property. For example, a Class A building at a 7 percent cap rate with $140,000 NOI will be valued at $2 million dollars.

$140,000 / 7% = $2 million

A commercial appraisal will typically calculate a value using each approach, and then combine all three, weighing each to fit the specific building and market being evaluated.

Financing

Generally, commercial loans have a set of underwriting standards that are fundamentally different from residential ones. Basic criteria such as personal credit history and loan-to-value are still relevant, but there are other factors that come into play as well. Where residential loans require that you pay back the loan with personal income, commercial loans are repaid through the cash flow of the property. Lenders will look at the amount of cash available to repay the debt after you’ve paid all of your operating expenses. Many banks will have a set income to debt ratio, called debt service coverage ratio (DSCR) that you will be required to maintain during the life of the loan. A DSCR of 1.0 means for every dollar of net income there is a dollar of debt repayment. Expect most lending institutions to require a DSCR of at least 1.25 — one dollar and twenty five cents net income for each dollar of debt repayment — before they consider a loan viable. Lenders do this to ensure there is enough money to cover unforeseen or emergency expenses that arise over and above the regular loan payment. In addition, commercial loans usually have higher interest rates and require a larger down payment.

Leases

There are numerous types of leases for renting office space, the three most common being the gross lease, modified gross lease and triple net lease. Gross leases usually benefit the lessee the most. The renter only has to pay rent, while the owner of the property is responsible for paying all other expenses such as utilities, repairs, insurance and taxes. A triple net lease is the opposite of the gross lease, where all burdens of taxes, utilities, maintenance and rent are the responsibility of the tenant. A modified gross lease is between the two – the tenant and the property owner share some of the costs (such as the tenant paying rent, utilities and taxes while the owner is responsible for building maintenance and upkeep).

While a triple net lease can often look to be the most attractive option for a landlord because of the cash flow, they can sometimes be risky. A renter who enters into a triple net lease may not be able to cover all of the expenses associated with the property, or will allow the building or property to fall into disrepair (in extreme cases, tenants have been known to intentionally damage a building to collect the insurance). However, most triple net leases contain provisions that protect both the landlord and the tenant, such as requiring tenants to pay into a reserve fund so that expenses can be paid in case an unforeseen emergency arises. Also, in some instances, there may be a cap on the amount of property taxes the tenant is required to pay, leaving the rest to be paid by the landlord. The most important thing to remember is to make sure all the terms of the lease are clear, fair and understood by both parties.

As a part of your due diligence, and certainly prior to closing, you will want to have all current tenants sign estoppel certificates. Estoppel certificates are simply an acknowledgement by the tenants that the lease they signed is still in full force and there are no existing issues that would cause either side to claim otherwise. It might sound like overkill, but it could be financially devastating to purchase a building only to find out that the biggest tenant is in the process of moving out because the previous landlord failed to fix the air conditioning.

Management

Unlike residential property, managing commercial office buildings can be a full-time job. Except in the case of smaller properties, it will most likely be advantageous to hire a property management company to lease, maintain and manage your buildings. There are a number of excellent firms that provide this service. They employ professionals that have their finger on the pulse of your market. This is particularly valuable when looking for new tenants as most savvy commercial property managers will have buildings full of tenants who are often looking to up or downsize. The fees are reasonable, usually running somewhere around 10 percent of gross rents for property management, with new leases done on a commissioned basis. If you are a serious investor who wants to spend your time vetting new projects, you should seriously consider having someone else take care of broken toilets, meeting tenants and negotiating leases on a day to day basis.

Investing in office buildings is a professional undertaking which requires long term commitment. It is, however, a rewarding one that can provide a constant source of income and opportunity for years to come. Like all investing, it is a balance of risk, work and reward so if you’re ready to take on a bigger challenge and move to the next level of real estate investing, then an office building might be in your future.