Big Profits in Small Offices
A nice office for his contracting firm was all Sim Farar was looking for when he bought his first small commercial building in Reseda back in 1978, but what he found was a new way to make a living.
Farar figured he would occupy part of the $150,000 building with his kitchen-remodeling business and lease the rest. But he soon found that he liked investing in office buildings more than he liked the contracting business, so he gave up contracting to become a landlord.
Today Farar owns five buildings in the San Fernando Valley, ranging in size from 3,000 to 10,000 square feet, and remains glad that he made the switch from tenant to owner.
“These [office buildings] have been the best investment for me,” said Farar, who also owns apartments and retail shops.
Small office buildings lack the glamour and rarely capture the publicity associated with skyscrapers that sell for hundreds of millions of dollars, but industry experts say there has always been a world of small investors quietly buying and selling such properties.
“There is a tremendous market for these buildings,” said Rick Gold, a senior executive vice president with brokerage Capital Commercial Real Estate. “There are pockets of these small buildings all over the place.”
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Small office properties have become popular with individual investors again after falling out of favor during the recession, said broker George Economos, a senior vice president with Grubb & Ellis in Newport Beach. The next few years represent a “window of opportunity” to buy small office properties, he said, because prices are rising steadily from their recession-era lows and rents are rising rapidly.
Many owners of small buildings suffered acutely during the last recession, when properties fell to a fraction of their former worth and lenders refused to finance purchases.
“Banks, for the most part, wouldn’t lend on these buildings from about 1990 to 1996 because the property values were declining and the leasing situation was unstable,” Economos said. He cited small office buildings in one moderately priced Santa Ana business park where sales prices dropped to $50 per square foot after hitting $130 per square foot at the top of the market.
But prices for those buildings have now climbed back to $75 per square foot and will likely go higher because rents are climbing, Economos said, so lenders are now much more willing to finance small-office deals. He said the interest in buying such properties has also grown in recent years among “individuals who have some money in the bank and want to diversify from the stock market.”
Small buildings can generate generous cash flow because lease rates are rising steadily throughout the office market and are up 10% to 20% from the recession in some areas.
“The income to the investor always boils down to lease rates, and lease rates are really rocketing right now,” Economos said.
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Farar estimated conservatively that owners of small office buildings can realize profits of 9% to 12% a year on their investments, although he now manages significantly higher returns on his buildings because he owns them free and clear.
The biggest returns on such buildings typically come when the investor sells after the property rises in value, said Kathleen Silver, a Grubb & Ellis broker in West Los Angeles who specializes in small office properties.
“Oftentimes the [monthly mortgage payment] is going to be very close to the income, so it’s pretty hard to make a sizable profit on the cash flow alone,” she said. “But over the long term, the prospects for appreciation are pretty good.” Silver said many investors in small office buildings begin, like Farar, as owner-users and become “real estate believers.” Often, they have chosen office buildings as an alternative or supplement to the stock market.
“If you’re trying to make a decision about whether to invest in Wall Street or real estate and you look at the history of both, you can pretty much find enough information to back either scenario,” she said. “A lot of the office investors started in real estate and have stayed with it because they’re comfortable with it.”
Individual investors often stick with one type of property--office, apartment or retail--based on strong personal preferences, Silver said.
“I know one investor who likes apartments and won’t touch an office building because he says everybody has to have a roof over their head but nobody has to go to an office,” she said. On the other hand, other investors consider office buildings more attractive and less of a management headache because office tenants tend to sign longer-term leases than the standard one-year apartment lease.
According to Gold, one benefit of owning small office buildings is that they can provide an advantage over larger buildings for landlords trying to land small tenants.
“If you have a 5,000-square-foot building and the tenant needs 2,000 square feet, you can offer [to put their company name] on the building because they’re going to be a big fish in a small pond,” Gold said. “That can be a strong selling point.”
On the other hand, Gold said, owners of small office buildings almost always lease to small companies that have a shorter track record and are less likely to be what the commercial real estate industry calls a “good credit tenant.” Small tenants are also less likely to commit to long-term leases because they’re usually uncertain about how much space they’ll need in the future, he said.
According to Economos, one peculiarity of investing in small office properties is that when times are good, they’re terrific, but when they’re bad, they’re horrible.
“You can go along with your building 100% full for a couple of years, and then the building will suddenly be 100% vacant,” he said. A typical small building of 6,000 or 7,000 square feet may contain only two or three tenants, Economos said, meaning that the loss of one tenant can represent half the owner’s income.
Farar echoed Economos. “If you have a big tenant, they might leave, but that’s a chance you have to take. To me, the benefits outweigh the negatives.”
Landlords faced with vacancies have to act quickly to keep from losing their profits, Economos said, so an office investor has to find a new tenant quickly or hire a broker to find one. Brokers typically charge commissions of 4% to 6% of the value of the lease, usually paid half when the lease is executed and half when the tenant moves in.
Whether it pays to hire a broker depends on how quickly a landlord can find tenants, Economos said, pointing out that paying a commission “can be cheaper than having the space sit vacant for months at a time.”
Another of the ups and downs in owning office space is the cost of “tenant improvements,” or customizing space to fit the tenant.
“One of the crazy parts of this business is that in good times the small operators can get away without spending any money on tenant improvements because there is so much demand for space. But during bad times, they have to spend more to attract tenants,” Economos said. He estimated the typical cost of tenant improvements at about $10 per square foot, considerably less than what is spent in luxurious office towers but still a meaningful expense for a small investor.
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Tenant-improvement costs are one reason office property investors should have some cash in reserve, Farar said. Investors also need to be able to carry the mortgage if they lose a tenant or two.
It’s also possible to save money by using standard forms for office leases, Farar said, but he hires real estate attorneys to execute his.
Farar said he has never sold any of his office buildings but came close once and is being tempted again by the improving market. The building he bought for $150,000 in 1978 is probably worth at least $300,000 now--not remarkable in light of the way real estate sometimes appreciates in Southern California. But he figures that the property was probably worth three times its original value at the peak of the last real estate cycle and in today’s accelerating commercial market, its worth is climbing again.
