Office Vs multifamily - why the same cap rate despite more risk?

Question

Anyone with experience owning both offices and multi-family properties able to share the relative risks of each? Looking to invest in class B properties between $450k-800k and 7-10% cap in Michigan. I've read that with offices "you're buying the leases and the building comes for free", but every office I see listed has 30-50% of revenue associated with leases expiring within 2-3 years.

It's difficult to be confident in lease renewals when I see hundreds of office vacancies large and small around Michigan. It's also a turn off that class B offices with only 2-3 tenants easily cash flow negative with the loss of one tenant. Compared to multi-family buildings in the same price range with 15-20 units that remain profitable with 3-4 vacancies, which are generally straightforward to fill, offices look more risky in almost every way.

Attracted to offices having lower maintenance tenants, but that doesn't seem worth the riskier investment dynamics. Cap rate is supposed to reflect investment risk, but 7.5 cap multifamily appears significantly lower risk than 7.5 cap office. Am I missing something?

Appreciate any insight from more experienced investors.

Daniel Chang · Answer

What weighs more, a pound of feather or a pound of gold?  What is a better investment, a MF with an expected IRR of 12% or an office with an expected IRR of 12%?  (The answer is that both investments are the same, keep in mind I used "expected IRR").  Caveat - If you were to define "risk" as the economists do, namely volatility, then yes an office property is likely more "risk" if you own one building with 2-3 units, vs a MF with 30 units.  But this has more to do with diversification.

As an investor, you never use the cap rate as advertised by the seller.  Of course a 7 cap advertised office is likely worse than a 7cap advertised MF.  However, a prudent investor would properly underwrite an office building factoring many things including expected vacancy rate.   You may underwrite a vacancy of 5% in a MF deal, but would underwrite a vacancy of 20% in an office deal.

You are correct, if leases are expiring in a few years and the seller is expecting to get "full value" of the leases at "market cap", then that's a deal to walk away from if the seller won't negotiate.

As an example, 2 years ago, I was negotiating on an office deal that had a new stable government backed 10 year lease, and didn't reach agreement.  1 year later, it was still sitting on the market.  So I went back and made another offer lower than my previous year.  This pissed the seller off, but he was willing to sell me the property at my 1st offer (the year prior).  I said "no, it isn't worth that anymore because there's one less year of guaranteed cash flow."  (No happy ending here, we didn't reach agreement and he took the property off the market right after).

Joel Owens · Answer

Nope not missing anything. Office is way more risk than multifamily. Should be buying with a 10 cap with upside unless Class A or medical office.

When economy goes down retailers for strip centers need a store front as destination tenants. Multifamily people need a place to live. Office many of the tenants can downsize to off the beaten path office locations or warehouse type space. They can also stay with you but reduce the space they want. Alternatively a small business can run out of their basement etc.

When economy is good business licenses applications are up.

Not a big fan of office but that's just me.

Oren K. · Answer

Michael,

Not sure what the 'offense' is. With commercial properties, you are buying based on existing cash flow. If the owner wants to be paid for the vacant units, they should fill them (with any associated expenses) and then market the property.

As with any rental property, there is a 'normal' vacancy factor that the seller is going to minimize and the buyer is inflate.

Owners wanting to be paid based on unrealized potential is much of what we are seeing in the MF space. I always get a kick out of seeing an OM where a space has been vacant for 2 years but is assumed to be fill-able in 6 months.

If the property does not cash flow (e.g. is distressed due to vacancy) then the ARV approach comes into play;

- What will it be worth once stabilized at current market rents?

- How much will it take (time & money) to stabilize?

- What rate of return will you be satisfied with?

- How much of fudge / contingency factor do I put in?

Each investor will answer these a bit differently depending on experience, market knowledge, contacts, urgency to invest, etc. Answer the above question and you can calculate what the current value of the property is to you.

Leigh Lommen · Answer

I know people who have been extremely successful in office investing in class B in secondary or tertiary cities.   One owns 6 million square feet (syndicated with 20 percent in own equity stack) and the other 2 million, sole owner operator.  They are very shrewd about tenants and TI. Returns in high teens to twenties.

Storm S. · Answer

You evaluate them by making assumptions about how long it will take to lease up the property and at an expected rental rate. You then build a projection for your cash flow for however long your hold period is and then do a discounted cash flow analysis. Your Net Present Value at your required rate of return will be your maximum offer.

Michael Anuzis · Answer

Oren K., I appreciate your insights and learned a lot from your posts. Thank you.

Michael Anuzis · Answer

@Joel Owens, thanks for confirming.

If anyone has had success with class B offices I'd love to learn more. It doesn't seem fair to conclude that office investors naively take higher risk for lower cap rates.

If I owned enough multifamily to cover costs of living and was sitting on excess liquidity I could see delving into offices to diversify, but it seems savvy investors may be able to make sound office investments more directly.

Related: investors in mobile home parks insist on valuing properties primarily on lots, mostly ignoring park owned homes. Given the office maxim "you're buying the lease and the building comes free", can someone confirm how empty suites are treated in practice? Valuing a 3-suite office with a vacancy as though it's a 2 suite investment seems likely to offend.

Office Vs multifamily - why the same cap rate despite more risk?

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