Office Sector Challenges: The Emergence of Office Condos as a Solution Amidst Sector Reimagination

he challenge facing the office market isn’t how to remain relevant today, the sector must figure out how to be a viable option for companies in a post-pandemic world. Shifting work patterns, work-from-home practices, and a tight job market, are all combining to create chaos for landlords. Demand has subsided for office space and supply and demand are no longer in balance. The result is there is simply more space available now than is being absorbed. Office landlords are revisiting strategies and creating work environments that seek to appeal to employees and energize leasing activity.?

But there is another approach that is emerging alongside those efforts, and it involves companies buying their own office space. Companies are exploring new uses and options in a time when less traditional office space is needed. Today, the condo model is an option that is helping absorb unused or unneeded office space, and it brings benefits to tenants, as well as has advantages for landlords.

David Lockwood, SIOR, CCIM, CRE , a CRE industry leader and office expert with Colliers in South Carolina, and SIOR’s current global president, says the trend toward companies wanting to own their own building was evident during the pandemic, especially in smaller, tertiary markets where local companies tend to dominate. “Those were the first markets to experience a full office staff returning to the office, which resulted in companies fully occupying and utilizing their space,” said Lockwood He went on to explain that smaller, tertiary markets subsequently haven’t gone through some of the challenges larger markets have in trying to change remote working habits.

Interestingly, it is the success of companies that’s driving a desire to own. Lockwood notes, “Smaller office properties, including condominiums, have been snapped up by users, and those are companies that, through the pandemic, have achieved good profitability. Those local businesses were owned by either LLCs or an individual. They grew tired of leasing space so they began purchasing owner-occupied space, which would include freestanding and condominium buildings. The condo market has been very, very hot because those owner users have purchased those buildings.”

For landlords unable to lease an office building or divest an asset, an office condo is a potential exit strategy, especially for smaller ones that appeal to smaller users. The appeal of owning rather than leasing became evident a couple of years ago when owner users bought larger buildings than they needed at the time. Additional space was leased out and today, while those assets may be more difficult to finance, they are considered an investment property versus an owner-occupied property, notes Lockwood. He says that is one reason those users have “turned back to the condominiums” creating a “really active, robust market.” Converting an office building into condominiums may be an exit strategy for an owner that is unable to lease a building, and it may result in them being able to achieve a higher selling price than if they sold an empty building, too.

Lockwood says owner occupier users more easily adopt an office condo strategy because they tend to think longer term. “Tenants typically think shorter term and they think, ‘My lease expiring in a year, I need to get find space to rent now,’” he says. In contrast, an office condo owner may have been saving up equity for a number of years. “They're looking for the right opportunity and they're a little bit more forward thinking. They may be more willing to wait on the delivery of an office product for two years,” says Lockwood, who notes that the office condo user base is not corporate America.

Companies have been able to secure financing and haven’t faced a lack of capital to acquire a building in which to occupy because their businesses have produced profits.

Taber Thill, SIOR , an office broker with Colliers focused on the Greater Las Vegas Valley, notes that the Las Vegas market is experiencing fairly low vacancy and the demand for office for both lease and purchase is pretty robust.

?“What makes a condo unique is it allows an owner to buy a small portion of a building that just meets their size,” says Thill. “It also allows landlords with larger buildings an option to go through and do a condo mapping to break that building up and create more value on a price per square foot basis.”

The cost to develop a large office building as a condo is cost-prohibitive, as is building a 2,500-square-foot or 3,000-square-foot office building. But a sweet spot for office condo development are buildings in the 10,000-square-foot range that can be demised into spaces in the 1,500-square-foot range. Thill, who is SIOR”s Office Member Group Steering Committee Chair, says, “That creates a unique option to own where a company wouldn’t otherwise have that benefit. Owning could allow them to take advantage of appreciation and depreciation, and companies can avoid drastic rent fluctuations, and their debt service will remain relatively stable.”

Thill advises companies to consider one drawback before stepping into condo ownership, that being planning for growth. Fast-growth companies may not be best-suited to an office condo, since they would likely out-grow their space too quickly. But CPA’s, law firms, or companies that typically don’t add more than three to four employees a year, could be ideal candidates for an office condo, he says.

Bringing an office condo project to market isn’t easy. Lockwood says there is an enormous amount of work and legal considerations involved on the front end. Developers take on greater risk and must invest in legal time to properly set up the office condo structure, including a Property Owners Association, as well as a framework for handling common areas.

Units must be properly sized, too. “Make sure that the units are not too large because the larger the unit, the more limited you are in who can actually purchase that,” says Lockwood, who notes that is one reason smaller floorplate buildings work well for office condos because there are more users in the 10,000- to 15,000-square-foot size range than the 20,000- to 30,000-square foot range.

Amenities are what set buildings apart, whether leasing or selling office condo space. Some of the same considerations that developers make when building a multi-tenant leased office property come into play with an office condo. That likely starts with a location with sufficient density and proximity to restaurants, and bars. Buildings with a fitness center or common area meeting space can provide employees with desired amenities but must be balanced against the cost. Those amenities take up space which may reduce the returns needed. Today, first-class gyms and workout facilities that feature high profile windows can be wise investments for condo owners because they help recruit top talent and may encourage employees to return to an office.

Thill says that the condo model typically functions similar to a multi-tenant office building when it comes to the areas and amenities outside of their own space. Each owner would pay a Pro-Rata share of things like maintenance or landscaping, depending on the size of its unit. Larger owners may have more say in the overall building since they have a controlling interest, though individual owners typically have more flexibility on what they do within their space.

A key aspect to consider in an office condo building setting is who the neighboring companies are to make sure there aren’t jarring conflicts or issues. Traditional office users may not be compatible with a medical facility or call center, especially if an office neighbor encumbers more parking than they’re allotted.

Absorption in Challenging Times

The office condominium option simply makes good business sense for some companies. But a big question to ask is can office condos help to absorb unused or unneeded office space? Thill believes it can.

“The short answer is, yes. Though I’ve not seen it executed on a larger scale, I've seen a couple of 40,000- or 50,000-square-foot, maybe three-story buildings that have gone through a condo conversion. And they were successful in that.”

Lockwood agrees but believes that the ideal candidates for conversion are older, functionally obsolete office buildings. In order to create tenant interest in older buildings today, it requires significant upgrades. That drives down the worth of that asset as a pure leasable office building, compared to the value that could be realized through a condo sale he says. “There are times when we look at some investment office buildings and tell the owner, ‘You’re building is worth more empty than it is leased right now.’ The reason is because there are users that are willing to pay more when it fits into the condo model,” says Lockwood.

Owners with large, empty office buildings must consider the risk to develop it into a condo building, including the legal factors and creation of the common areas. But Lockwood believes there are companies earning strong profits that are willing to buy those units to occupy. They are still able to secure reasonable financing as an owner-occupied borrower and it can produce a compelling exit strategy for a landlord.

“Owner occupiers are buying an investment that will appreciate over the years,” says Lockwood. “Landlords are not entitled to a loan payment to build up equity in the property. They potentially have an exit strategy to sell it in the future, as opposed to walking away from leased property. Higher values may be achieved by selling the space as a condo compared to leasing when lease rates are depressed.”

What’s in in for Tenants amp; Landlords?

Market activity for the office condo sector is driven by the correlation between rents and debt service. “When rents and debt service are equalized, that drives activity and ownership,” says Thill. “Despite some softening nationally, ownership has remained resilient. The same softening is also causing owner occupants to hold on to assets in a tighter market.” Lenders are shying away from office until demand stabilizes and return to work practices prove more resilient.

A benefit to weigh for an office condo is the fact that the company generally occupies 100% of the space, so SBA financing can be considered, as well as other creative financing tools. Thill says, “Another benefit to weigh is tenant improvement costs. Labor and material costs are soaring dramatically nationally, and the allowance landlords provide tenants to build out their space isn’t covering those costs. Now, tenants are required to come out of pocket to cover the costs, which could be 2 to 2.5 times higher. Taking an office condo route gives companies the ability to invest in their own future.”

There are other considerations as well. For instance, companies that own their own office space have tax advantages beyond appreciation as was noted previously. Some of the tenant improvements to a space can be financed, and occupancy costs can be more stable due to having a flat fixed rate mortgage rather than rent increases tied to CPI.

Meanwhile, landlords reduce some of the burden they carry with an office condo approach. Even though tenant improvement costs are rising and some of that expense is being carried by a tenant now, a significant amount of tenant improvement costs are still borne by a landlord. Since a condo building is typically sold in a shell condition, the landlord would not need to outlay tenant improvement dollars.

The value created by creating a condo building may make this option viable. “Condo buildings have tended to sell at a higher price per square foot than a whole building,” says Thill. “The pool of office condo buyers is larger because there are more companies seeking to buy a 20,500-square-foot building than a 45,000-square foot or larger asset.”

“Corporations are still going to lease space. Individual owners of companies or LLCs that own the company are the ones seeking to invest in real estate,” says Lockwood. “And it is being driven by their success, even through the pandemic. They want to invest their profits into owning something rather than continuing to lease.”

While higher interest rates have put a slight damper on plans, companies view owning the space in which their business operates as a smart, strategic, long-term move. If interest rates move down, that will position those companies well, they can refinance and their decision to own rather than rent their office space will likely fuel future business growth. The office condo option is a strategy companies are continuing to explore that offers a bright spot amidst a major reimagining of the office sector.

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