Investors Who Overlook This Key Cost Factor Could See Profits Wiped Out in Their Next Office Deal
CoStar Analysis: Rapidly Rising Capital Expenditures Are Taking A Bite Out Of Profits For Office Investors
BY PAUL LEONARD (via CoStar Group)
Higher costs associated with keeping office properties competitive with newer buildings is an increasing concern for investors. Shown here, BNY Mellon Center at 1735 Market St. in Philadelphia sold this week for $451.6 million. Photo: CoStar.
Office properties today are priced to near perfection, leaving very little wiggle room for investors who are surprised by unexpected costs. Underwriters seeking to determine the future net operating income (NOI) typically used for pro forma valuations of potential acquisitions traditionally focus on above-the-line operating expenses, such as property taxes, utilities, management fees, and more.
But savvy investors should pay closer attention to what’s happening below the line, specifically to capital expenditures. Some nasty headaches could await buyers if they are not factoring significant increases to capital expenditures into their underwriting.
On the surface, investing in office property has been a good bet for more than a decade. Nationally, average NOI growth has increased steadily, growing at a 3.9 percent compound annual growth rate since 2006.
Meanwhile, operating expenses for office properties have only increased at a 3.6 percent compound annual growth rate over the same period. Operating expenses as a percentage of income have actually fallen from a peak of 46.3 percent in 2008 to 42.7 percent in 2018.
But when capital expenditures (CapEx) are factored in, the rosy outlook for investors returns is altered. CapEx increased at a 4.6 percent compound annual growth rate since 2006. And net operating income after subtracting CapEx — in order words, cash flow– has only increased at a 2.9 percent compound annual growth rate over the same period.
Moreover, the rising gap between traditional net operating income and this adjusted NOI inclusive of CapEx—shown as the red line in the cash flow-to-NOI ratio in the above chart–clearly exhibits the erosive power that inflated capital expenditures have had on profitability.
Flight-to-quality among office users has been the overarching theme of the office market this cycle. Landlords are being forced to renovate their buildings and make them more competitive if they want to survive. With upwards of 80 percent of office demand each year going to higher quality 4- and 5-Star-rated buildings, owners of average-quality properties must increase capital expenditures to attract and retain tenants.
In certain premier urban submarkets, even landlords of high-quality office properties that are a few years older are facing fierce competition from new buildings. Examples of the phenomena abound in every major market, such as New York’s Hudson Yards, the Transbay Center/South Financial District in San Francisco, and Boston’s Seaport District. Millions of square feet of ultra-modern 5-Star office space has already been built in these areas, and more is on the way.
One of the largest contributors to the increase in capital expenditures has been office fit-out costs. In a 2018 office cost benchmarking report , JLL reviewed thousands of tenant fit-outs in office projects across North America and determined that the average cost for a moderate fit-out of second-generation office space was $158.23 per square foot.
The study defined moderate office style as a balance between an open office work environment and one with dedicated private offices. Second-generation was defined as previously occupied office space provided in a condition ready for tenant improvements.
JLL also reported that landlords contributed an average of $40 per square foot of tenant improvement allowances, or 27.5 percent of the total fit out cost as a concession.
Tenant improvement allowances have doubled over the past decade, growing four times that of core inflation on consumer goods over the same period. Facing pressure to secure and retain tenants, some building owners are offering increasingly larger tenant improvement allowance packages to compete. Covering a larger share of the growing pie of office tenant fit out costs has led to hefty bills for landlords.
Building costs are also rising rapidly, at two times core inflation, another key factor causing capital expenditures to rise.
Both these trends have occurred in a strengthening office market, and it is likely that tenant improvement allowance concessions could accelerate further as the market reaches equilibrium and eventually turns downward.
Building cost inflation has increased unevenly across the country. Generally, the primary markets have faced the strongest increases in building expenses. Since 2006, building costs have exceeded 40 percent cumulative growth in Boston, New York, Chicago, Seattle, and San Francisco. Sun Belt markets such as Dallas (36 percent) and Atlanta (23.4 percent) have had less pressure on buildings costs.
The cost of construction labor has been the main culprit for the additional costs in the large gateway markets. Construction workers are in high demand, particularly from multifamily developers, which has led to a shortage of skilled tradesmen and has put upward pressure on wages.
A lower cost of living in the Sun Belt markets has had the dual impact of attracting migrant construction workers from more expensive markets and keeping wage inflation lower for these workers since they have more purchasing power in the lower-cost markets. This trend is unlikely to abate anytime soon.
Also contributing to costs is the strength of local labor unions, which are generally stronger on the coasts and weaker in the Sun Belt.
Today, the office market is at an inflection point . Rent growth has decelerated for the past three years and likely won’t outpace inflation in a majority of markets for the remainder of this expansion. Office rent growth momentum, which measures annualized rent growth on a two-year backward (2016-2018) and two-year forward (2018-2020) basis, has been favoring secondary markets in recent years.
Office investors in Boston, New York and San Francisco face the greatest risk of being squeezed. Not only are these the most-expensive markets in the country, but pricing is at all-time peaks, and with sub-5 percent average capitalization rates, they each face upward pressure going forward from rising interest rates.
Rent growth momentum for all three of those markets has been anemic with San Francisco (1.8 percent), Boston (0.9 percent) and New York (-0.1 percent) all recording growth rates that trail core inflation.
Los Angeles, Chicago and especially Seattle are better-positioned to absorb rising building costs due to better rent growth momentum. But all office markets at this stage of the cycle are facing challenges from escalating capital expenditures.