Monday, May 24, 2021

Office Real Estate is Un-Underwriteable

Typically you underwrite deals using real time data. You use rent comps from the last few months to come up with your rent and tenant improvement assumptions. You use sale comps from the last few months or years to come up with a residual value. You use recent market trends to forecast absorption / general vacancy rate. Etc...

The quality of this data varies based on the asset class, how many comparable properties there are to pull data from, how reliable the data source is and how fresh it is. On one end of the spectrum is apartments. Typically in a primary or secondary city you can find many comparable properties that are nearly like-for-like in every way, can get real time rent info instantly (just go on their website or secret shop for the apartments) directly from the source (the actual property manager) and the info is obviously very fresh (as of that day). Oh, apartments also trade every couple of years it seems, so there is always abundant sale comp data. Apartments have the best data available and it's, I would say, subsequently the most efficient asset class. Pricing is very transparent and bidding processes likely have very tight spreads because bidders are all using very similar assumptions because they're using the same widely available, accurate data.

The other end of the spectrum is office. In many markets, other than large CBDs, there are few like-for-like comparable properties, lease comp data is very hard to come by (you have to know which brokers to reach out to for comps and you have to hope they have accurate data) and it may be very stale. The best lease comps you get might be from a year or two ago. In office there's also an insider trading element that exists. In a given building, an investor may have a massive edge over another investor because they know someone in the real estate department of the building's anchor tenant and they heard through the grapevine that the tenant is leaving at the expiration of their lease. Or they know the right broker and the broker gave them a heads up that a large tenant is going to be looking for space at that building and, if they give the broker an enhanced fee, there's a good chance the tenant will ultimately pick that building. Good data is tough to come by and, subsequently, pricing office real estate is extremely difficult and you can get some huge spreads in a bidding process. If a deal is being marketed for $40 million, it wouldn't be crazy to see bids ranging from $35 million to $43 million.

Given how hard good data is to come by in a normal market for office real estate, imagine how difficult it is with covid going on. During covid, there are hardly any new lease deals getting done, nothing is trading, there is a complete dearth of comps available. No one really knows what the rent is in a market, what free rent is being given, etc... Deals that are actually happening no broker wants to share or let out into the market because there probably at low rent rates and that info will be used by tenants to negotiate lower rates, which is bad for brokers and landlords. To make matters worse, nothing is trading. No one knows what cap rates or discount rates an investor will demand. So in the complete absence of lease and sale comps, and given the monumental shift that's occurred in the office market, how can an investor underwrite office real estate and figure out what the right price is for an asset?

Unfortunately, I don't think you can use data to value office real estate right now. I don't think there's a standardized methodology that you can apply to deals. Successful investors will navigate this market through gut feel and bold predictions about the market. It's going to be someone who has been through down cycles in the past, has a view of how things are going to play out post-covid (that turns out to be correct), is willing to put a bunch of skin in the game via recourse guaranties and has a stable of capital partners that will invest alongside him / her even though there's a complete lack of data in the market. This is the type of market where fortunes are going to be made. A complete lack of data and extremely uncertain future mean the market is going to be inefficient for a while. Some investors with the traits previously mentioned are going to take advantage of this inefficiency and hit some massive homeruns.

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