Back in March, I had the privilege of participating in an Office Condo Seminar in Miami, Florida. Several other real estate and lending professionals joined me, and we were able to answer questions from folks who are curious about commercial condominiums. Even though they’re becoming more and more common, business owners still have questions about them and wonder if they are worth the investment. Below, I’ve included a portion of the Q&A session, which will be helpful if you or someone you know is considering purchasing a commercial condo . . .
Q: There has been quite a media backlash recently on some office conversions. Why are some of these projects not succeeding and where will the market end up?
Salsburg: Quite simply, bad news sells in the media. That’s one reason you’re seeing these stories. However, it’s important to note that there are some projects that are not working because of their location or price point. I believe office condos are not going away. Instead, I think it’s like the residential condo market. There are some buildings that won’t make it and some that will.
In addition to location, one of the key issues is whether the property was purchased at a sound price. That’s largely what this market turmoil is about. I think some developers are just chasing dollars, while others are coming late to the market and will wind up chasing the train.
Rollnick: I started practicing law in 1968 and in 1972, I created the first commercial condominium office building in Florida-it still exists today. I’ve been through these cycles before, and the trends in 2007 and the media backlash is not new. In fact, it’s happened several times in the real estate cycles since 1968.
You have some developers who wisely pick and choose the right niche in the market, the right location and the right property to develop or convert. And you have people who are not that experienced or not that wise who jump in looking for the fast buck. There will always be a sorting out of the good product from the bad product.
In regard to the newspapers, I’m not an optimist or pessimist. But I know that doom and gloom sell; therefore, there can be a self-fulfilling prophecy of doom. Tell people there’s doom and they believe it. The headlines just reinforce the negative and downturn becomes a self-fulfilling prophecy.
Q: A number of office buildings were brought several years ago and not converted. What’s the normal time frame for a conversion to take place?
Gottesmann: One of the differences between a flipper and a developer is the ability to look at costs and the marketplace. A flipper might buy a building for $200 a square foot, hoping to sell the space for $400 a square foot. But that might not be a realistic selling price. Plus, when you buy a building you need to look at the current leases and condition of the property.
When you start in on an office conversion, there are a lot of upgrades that need to be done. You must bring it up to the current fire code and ADA [American with Disabilities Act] code, for example. An inexperienced developer might not realize that until after the purchase. Then, they understand what they need to do and just how much it costs. As a result, they get stuck in a cost squeeze and can’t go forward. The worst situation is when they start a condo conversion, sell 20 to 30 percent of the units, and then get stuck.
Q: What should a consumer be looking for to avoid the situation? No one wants to be the 20 percent or so who have bought space in building when the developer says “I’ve had it.”
Gottesmann: Come and talk to NR Investments!
Checa: Be sure you have both an attorney and a realtor represent you. There should be a section in the contract that says there’s a presale contingency. The transaction can’t close until the developer reaches a certain set percentage of sales. And if a building has reached 50 percent sold, most likely the developer will continue to proceed. So if sales are only 20 percent and you’re among that percentage, the transaction won’t close.
Q: In ground-up condos, we’re seeing delays by a year or longer. Are you seeing termination rights in your contracts to protect buyers from these delays?
Gottesmann: There are provisions in the contract that say a building must be built and occupancy given in a defined period of time. That time period varies depending on how the contract is structured and when the building is expected to be out of ground or converted.
The lender also sets certain requirements and the developer must meet certain thresholds along the way. So these provisions in the agreements and proposed condo documents are protective for the end user.
Beyond that, how do the end users protect themselves? Yes, you should get an attorney and a Realtor®, but you should also do your research. Look into the developer and find out their experience and history. What has been successful and what has not. And look at the lender as €
Hurn: As a lender, many times we know more of what’s in the condo documents than the buyer does. Therefore, I would urge everyone to read the documents. There are situations where construction is delayed, especially on a ground-up condo. I remember one client we approved 3.5 years before the building was completed and the transaction closed. The client today is very happy because the space is now selling at a much higher price. This situation happens all the time. It is painful for the end users and for the developers, too.
So you really need to read the condo documents before closing. I’ve had clients ask me about having to pay part of the seller’s closing costs or whether or not they get a parking space. I encourage users to read the documents, understand the requirements and learn the deadlines.
Gottesmann: Many people are treating these offices like the residential condominium market. I disagree. These are sophisticated buyers who should use an attorney and a broker in these transactions. The buyers are people who are running a business and understand at least the basics about buying office space.
It’s not a matter of showing the buyer a pretty picture-it’s a business process. We give buyers files with all the measurements of their space. We help them decide how to buy and how to design their space, and work with their accountant as well. In face, we are helping with so many things, that no one can say later on, “I didn’t know this or that” about my condo. That’s one reason why we like this market. Our buyers are educated people. We help them by giving them exactly what they need. And in fact, buying an office condo is not for everyone.
Checa: I want to point out that there may be clauses in your document that you don’t want used. For instance, if the building is delayed and you get out of the transaction six months prior to closing, you could be losing out. In many cases, the price for space will have gone up in the meantime. So you want to talk to a broker as well as a lawyer so you can make a good business decision.
Q: Is there a metric as to what makes sense financially?
Checa: We are passing on more projects lately because of unrealistic financial expectations among developers and converters. We analyze the current rent roll and the expectations on sellout prices. Then we ask whether we can sell it at that price or not?
If the numbers just don’t work, it is better to cut your losses at the start and not waste time. It’s simply a matter of the values in the market. We sell value, not price-so if there isn’t a lot of value and you can’t sell on price, it’s better to get out of the project.
Nearly all the good conversion buildings in South Florida have been bought, so I see more new construction than conversions in the future.
Gottesmann: If you ask me how we do it, I can share with you the basics of our formula in terms of strategy, price and location. We believe their price for condo space is an indication of the rent in the area-it’s not something you can set based on the cost of constructing or renovating a building. For instance, if rental rates are $20 per square foot triple net, we try to sell space for no more than $300 TO $320.
And we prefer to sell space fast for less profit rather than holding out for the highest price. Why? We’re creating a reputation of giving added value to our clients. And it lets us move from place to place more quickly so we don’t get stuck in a particular project. This strategy also lets us do developments on a bigger scale.
Finally, if we want to sell space at the right price, that means users will pay less money by buying than when they rent the space. Providing that added value to our customers is the key. So it’s important for end users to understand the economics.
Q: We’re seeing office condos selling large spaces from 10,000 or 12,000 square feet on up. Is there an economic number where it doesn’t make sense for the end user? Why would you want to get into an office condo of that size rather than own a freestanding building? Also, is there an inability to resell that amount of large space?
Checa: There are different answers to the purchase questions, depending on the company’s future goals. Buying a freestanding building gives you more freedom, but you will pay more as well. And in some prime locations, such as Coral Gables, you can pay twice the amount per square foot for a new building rather than buying a condo-and you won’t get as much parking, either.
That’s one reason many large companies are buying floors of condo space. Another is their relationship with other companies in the building, as well as the amenities that come with an office condo. And if you buy preconstruction you will usually get a good deal, too.
If you are buying floors, you’ll get a better price than if you’re buying smaller space. Those economies of scale also apply to the improvements and buildouts, so look at the numbers and see if they make sense.
But as the size of the transaction gets larger, there are more risks to the buyer. So you might want to research the company’s future along with the building itself. The bread and butter of the office condo market is still 1,500 to 3,000 square feet- that’s where the buyers are today.
Hurn: It can be hard to find well-located stand-alone buildings in your price range or in the right location. Many professional firms want certain locations, like a law firm that needs to be downtown or close to the courthouse.
Rollnick: There is also the maintenance factor to consider. Having owned an office building and rented it out, I know that you’re the person responsible for calling the plumber, electrician and roofer when problems occur with a 5,000 to 20,000-square-foot property. So you have a factor in the cost of that type of intrusion in your business life versus owning 5,000 square feet in a 50,000-square-foot condominium building that has a maintenance team on-site. If the HVAC system goes awry, there’s someone capable of repairing it. Of course, if you’re a 100 square-foot user with your own building, you’ll have your own maintenance staff as well.
Q: When the condominium structure is created by the converter or developer, the units are appointed in a certain way. What happens if someone wants 10,000 square feet and that space is sold as one condo unit? Can that unit later be split into multiple condos?
Rollnick: Generally, the answer is no. The best way to avoid that situation is to work with a design professional to create the lowest common denominator for your space. Rather than a 10,000 square foot suit, you might want to have five condo units, each with 2,000 square feet. By setting up the space in that way, you may be able to sell off portions in the future.
Gottesmann: But the developer needs to plan ahead on how to sell the building. Therefore, it’s important for users to read the condominium documents in advance.
Q: What percentage of office condo buyers are speculators and is there an oversupply in the market now?
Gottesmann: There is definitely not an oversupply. South Florida’s office buildings are rented out. The vacancy rate in the market is going down because developers for many years concentrated on residential buildings rather than new offices.
The question is whether we are going to repeat the same mistake in this market; I don’t know the answer to that question. But as long as we are converting existing buildings at the right price, we are filling a need in the market-this is not about speculation.
Also, my business partner and I decide we would be careful about who purchased space in our buildings. We didn’t want to encourage the speculators. We had some people ask to buy 30 to 40 percent of a building, but we said no. We’re in the market for the long run; the investor has a shorter time frame, so he doesn’t care much about things like maintenance. It’s hard work to sell individual units, but we are very consciously targeting end users. Even if the sale process takes longer, it’s the safest way to sell.
Checa: You can also sell at a higher price per square foot to the end user compared with a speculative investor. I also think it’s important to differentiate between speculators who hope to buy preconstruction units and flip them, and investors who put in a tenant and rent out the space. We encourage that type of investment in good projects.
Buying a large space and renting to another company in the future can be a very good strategy. For instance, we have investors who create executive suites and rent them out to individual business tenants or small firms. That suit then becomes an amenity for the entire building.
Q: Is downtown Fort Lauderdale a viable market for new condominium office buildings?
Gottesmann: Definitely. There is a need there.
Q: What parking ratios do you typically see in your buildings?
Gottesmann: You need to give parking to your tenants. Therefore, we typically have a 3/1,000 ratio [3 spaces per 1,000 square feet], and we create a valet parking service also.
Checa: You can allocate too much of the property for parking and reduce your sellable price. We shoot for 2 per 1,000 and aim for a ratio of 3/1,000. However, you do need more parking for a medical office. In many buildings, you can set it up so employees can use the designated parking spaces and visitors can use a valet service with vehicles parked off site.
Q: Is parking always part of a condo project?
Checa: It varies. We include parking in the sales price; sometimes the buyer can purchase or rent additional spots, depending on availability. A lot depends on the building’s footprint. But buyers should be sure to ask whether parking is included in the sales price; some developers reduce the price, but charge you separately for parking, so you want to compare apples to apples.
Q: What is the best-kept secret loan product for buying office space?
Hurn: First, let me point out that we are focusing on end users, and the idea of commercial property ownership as a means of wealth creation is a new idea for a lot of folks. That’s part of the education process that we provide. For a lot of small businesses, the current exit strategy is to sell the company or shut it down. A wealth formation secret is to stop paying a landlord and retain ownership of the real estate through an LLC [limited liability corporation] or other structure.
Now, for most businesses, cash flow is king. One of the main reasons a business owner does not purchase property is because they can’t part with the capital they think is necessary to buy. And if the business enjoys a high net margin from its ongoing operations, the owner should put as little capital as possible in the office property. That’s basic economics.
While it usually takes 20 to 30 percent down to purchase commercial property, that’s not always the case. We offer 90 percent loan-to-cost financing, and that’s different than a loan to value (LTV) program. We take the purchase price and include the tenant improvements and other soft costs and finance 90 percent of the total purchase.
That has allowed a number of office condo users to buy more space then needed, and lease out the extra area. Other buyers have used this financing for their buildouts, such as cubicle spaces or high-tech audiovisual equipment. The result can be a dramatic improvement in the business’ cash flow, and the owners don’t have to liquidate their personal savings to buy space.
Q: When do people approach you for a loan? And what happens if the costs go up after you’ve already worked out the loan package?
Hurn: About half of our office condo loans involve new construction. We understand that with construction, as well as with tenant improvements, you have to have some flexibility- it’s not always a matter of black and white.
We have never had a construction project that came in at the original budgeted amount. It just never happens. So you have to be prepared for a 10 to 15 percent change in the costs. We typically build in contingencies of 5 to 10 percent on our construction loan and that helps. The buyer doesn’t always use it all- but we know that construction tends to be an evolving process, not a straight line.
Q: What does creating a “green” building add to the construction costs and benefits?
Checa: There is a misconception in the market about the costs of going green-that’s one reason Miami is so far behind places like California and Washington. Over the past few years, our developers have been too busy buying and selling projects to worry that much about energy efficiency. After all, why build green when you can sell out in two days?
Our company has been looking closely at this issue for the past few years. The benefits of an energy-efficient building include lower long-term operating expenses, higher appreciation rates down the road and the intangibles, like being able to sleep better at night knowing you’ve done something to help the environment. The added cost is between 2 and 10 percent, depending on the level of certification you seek [from the U.S. Green Building Council’s Leadership in Energy and Environmental Design (LEED) Green Building Rating System™.]
Gottesmann: It’s definitely more expensive to create a green building. I guess my partner and I are two nutcases-we saw the movie “An Inconvenient Truth” and wanted to do something to help. As for the hard costs, I agree with Bert’s numbers.
Q: Do any buyers actually seek out green buildings?
Checa: Yes. There are companies and professional firms, such as architects and designers, who prefer to be in a LEED-certified building. For them green is just the gravy; they expect to benefit from lower operating expenses due to reduced consumption of electricity, as well as from rebates that impact the bottom line. And when they sell, the space sells for a higher price.
Q: What should buyers consider when looking at the cost of tenant improvements?
Gottesmann: The first step is education. For instance, with new construction, the builder typically gives you a shell. The cost of completing that space is usually higher than when you’re dealing with a conversion, which comes with a floor and ceiling in place. You might be able to spend a few thousand dollars, put in a workspace dividers and equipment and be ready to go.
Hurn: When looking at your real estate expense, you have to factor in all the costs. You might be looking at space in a building shell or one with minimal tenant improvements in place. So you have to determine your cost per square foot when your space is finished versus the alternative to continuing to lease.
Of course, that’s not quite an apples to apples comparison, because you have to look at the changes over time. With ownership, you generally benefit from appreciation, which historically has averaged 3 percent a year.
On the other hand, rents historically have gone up 2.5 percent per year. So, if you expect to own the space for 10 years, you need to project the projected rents for that same period to get a good comparison. And if you sell your space in 10 years, what appreciation can you expect. In our experience, owning makes more economic sense than renting in most cases.
Checa: Unfortunately, sometimes the sales team doesn’t sit down with the buyer and work through those calculations and explain those advantages to them.
Gottesmann: The key thing is to take the buyer’s hand and help the client. Some people don’t want new construction because of the longer time frame or other factors-but for others, it’s their dream. We believe in a case-by-case approach and talk to each client about their specific goals.
Q: Could you discuss exit strategies when you own an office condo? And since this condo market has not been around for a long period, do you have a sense of how well you could get out of your space in ten years? No one wants to be stuck with a property that’s very hard to sell.
Rollnick: We advised developers on several office condo buildings many years ago. Since then, the original buyers have retired, sold their business or moved to a different location. While I can’t quantify how well they did financially, they didn’t have any difficulty in selling or renting the space, depending on their preferences.
It seems to me, though, that there’s another issue to consider. The same scenario arises when the business owner is a tenant. Many times the sale or exit strategy does not coincide with the terminus of the lease. The buyer might want the business, but not want to be strapped with an existing lease. In that case, owning your space is a clear advantage.
In this environment, office condos are not as well known or as seasoned as in the residential market. So it reflects a built-in jaundice to say, “I have to be able to get rid of the property.” But these business owners don’t recognize that they have the same problem when they’re leasing.
Hurn: It’s also important that the owner not be too extravagant with the buildout. An office is an office-if the location is right and the price is right, the space will sell. It’s the same situation as with a freestanding office building.
Gottesmann: Many business owners spend more time in the office than in their home. And ownership gives them more control of that space, as well as providing financial benefits. Clearly, office condominiums are not a trend they are reality. Condos are 15 percent of the market here and there’s room for growth. In South America, for instance, everyone owns- no one rents their office space.
Checa: In addition, it’s important to remember that an office condominium is a democracy leasing is a dictatorship run by the landlord. With a condo, the owners can say, “Let’s add one more security guard” and get it done right away.
Q: For me, one of the most difficult parts of buying an office condo is going through the mortgage process. What paperwork is involved in an approval?
Hurn: This is one of the biggest purchases that anyone makes so you want to do your due diligence on the lender. Look for someone with experience in financing this product type, who has the products and is comfortable with the concept. We have streamlined a lot of the process for our clients, and have closed loans in as short as 27 days from the pre approval. There is a lot of anxiety associated with buying a commercial property. We want to take that anxiety away by approving a loan in 24 hours or less it’s one of our differentiators in the market.
Q: From a developer’s perspective, is it better to build an office condo or for-lease product? And what are the best submarkets for office condos?
Checa: The right answer depends on your business strategy and return goals. If you want to be in and out with a smaller return, you might consider an office condominium. If you plan to break even for five years or so, and profit later on, you could construct a building and lease it out. As for the best markets, I think Brickell and Coral Gables are very good if you can find a suitable site for a new building.
Hurn: You could also look at entering new metro markets. The office condo concept has taken off in South Florida, Orlando and Tampa, but we haven’t seen much yet in markets like Jacksonville.
Q: Will the office condo concept work in smaller markets like Gainesville or just in the larger metropolitan areas?
Checa: That depends on the rents in the local market. Condos could work in Gainesville or Vero Beach or anywhere else if the price is right and it makes sense for businesses to buy space. But a developer also needs to market that product effectively.
Q: Do you find that smaller end users-say those wanting 1,500 to 3,000 square feet-plan two years ahead for new construction of 18 months for a conversion?
Hurn: Most businesses should be doing that, but in fact they aren’t. Their focus is on running the business every day-that’s why it’s important to offer a package deal on an office condo that includes the tenant improvements.
Checa: With today’s low vacancy rates, even a tenant with 500 square feet can work with a broker and start planning ahead. An office space user needs to look at least six months to a year in advance if they are considering buying and renovating a space. The larger the tenant, the longer the time that should be spent in the planning stage.
Q: Once the conversion has been completed, how do you handle the management of the property?
Gottesmann: The developer should manage the building professionally until it is delivered to the condo association. Then the owners can choose whomever they want for the management.