5 Things Investors Should Know About Office Real Estate

For many strategic investors, office real estate is an attractive opportunity to diversify a portfolio and capture healthy returns. Strong underlying fundamentals and long-term income potential make the asset class appealing to both institutional and individual investors.

If you’re considering an investment in office real estate, here are five key things to know:

1. The unique characteristics of office real estate

Unlike multifamily or hotel real estate, office real estate is characterized by long-term (typically 5-15 year) leases. For this reason, there are various distinct features that investors must evaluate when considering an investment in office real estate. The following factors are commonly considered:

• Location:* Central business district vs. suburban; economic and demographic conditions of the given area
• Size: High-, mid- or low-rise structure
• Tenant type: By industry, e.g., government entity or technology firm; single- vs. multi-tenant
• Tenant credit: Buildings occupied by Moody’s or S&P investment-grade tenants (or, for smaller and unrated companies, any proxy thereof) will typically trade at lower cap rates (higher prices) given the income from their lease payments may be deemed more “secure”
• Weighted Average Lease Length (WALL): This metric indicates the average remaining term on all of the in-place leases in single and multi-tenant buildings, signifying how much time an investor has before renewing or re-tenanting the existing leased spaces
• Class: According to the property’s age, amenities, infrastructure and need for maintenance or upgrades; Class A buildings are coveted spaces with new, top-notch features; Class B buildings are typically 10-20 years old with middle-of-the-road services; Class C buildings are often 20+ years old and out-of-date or in need of repair
• Type of space: Traditional layout vs. open or creative space

A thorough due diligence process also includes an in-depth review of tenant financials, tenant interviews to assess their needs and desire to remain in the space, lease structure (any break or renewal options, etc), and operating expenses (often reimbursed by tenants to some degree).

When it comes to leases, length and terms are important. Office real estate lease lengths have been relatively stable in the U.S. for several decades. In general, length is proportionate to the size of the lease. Leases for offices of 100,000 square feet or more are typically around 10 years, while leases for spaces 15,000 square feet or less are closer to 5 years.^[1] For investors, lease length of office real estate generally makes cash flows more stable and predictable, while delaying a building’s response to increases or decreases in market rents.

Many smaller office buildings (and a few large-scale ones) are leased under longer-term triple-net (NNN) leases. This structure requires the tenant to pay all of the property’s operating costs in addition to a base rental rate. Operating costs typically include property taxes, insurance, and maintenance both of their space and common areas.

Properties with NNN leases can be particularly attractive real estate investments given their reduced re-tenanting risk and overhead: NNN leases place the burden and unpredictability of operating costs on the tenant, rather than the investor or owner. Investors are therefore positioned to receive a stable and predictable income stream, barring any default by the tenant. Investors can also benefit from the simplicity of NNN leases, since the landlord is relieved of responsibility for completing many of the typical day-to-day service requirements.

2. The key macro drivers of demand for office real estate

Investors should also understand how the overall economic environment influences demand for office real estate. A growing economy supports healthy demand for office space. As the U.S. expansion continues, fundamentals remain healthy for office real estate. Vacancy rates are near cyclical lows and rent growth is positioned to push higher on the back of supply constraints.^[2]

More specifically, demand for office real estate is closely linked to a particular type of employment growth: Jobs that require office space. These office-using “white collar” jobs include financial and professional service employees such as attorneys, accountants and people working in banking, consulting and pharmaceutical fields. Growth in office-using employment in the U.S. is expected to be 1.6% in 2019, a bit slower than the approximately 2% rate seen in 2018. While labor market constraints and skill shortages in some areas may hinder office-based employment growth, employment rates are still positive and expected to help drive continued office market expansion.
Investors should certainly strive to understand nationwide economic and employment trends—but with office real estate, it’s equally crucial to be knowledgeable about conditions in the region or city where each property is located.

3. Job growth in the technology sector is shaping demand dynamics

In recent years, changes in the technology sector have become a major factor affecting demand for office properties—and strategic investors are taking note.

Source: CBRE, as of Q3 2018

Across the U.S., companies in the technology sector and related industries are vital drivers of demand for office space. It all comes back to jobs: The technology sector has added more than 1 million jobs in the U.S. during the current expansion, representing an increase of nearly 19%, handily outpacing other industries.^[3] Since the beginning of 2017, technology companies have accounted for more than 40% of the square footage in the top 100 leases in North America—more than double the share of the number two industry, financial services^[4] — and they currently represent approximately 25% of space requirements.As such, areas that are home to a large base of technology companies are seeing strong growth in demand for office space, including the San Francisco Bay Area, Silicon Valley, Seattle and Austin.

4. Flexible spaces fit the needs of an evolving workforce

Another notable feature of the current cycle is the shift toward more flexible office spaces. The gig economy is thriving and corporate attitudes are changing as we witness an evolution in how, where and when people work. Thanks to better technology and connectivity, the modern employee is redefining what it means to work in an office.

Companies are responding to the preferences of an increasingly dynamic workforce by embracing flexible spaces. Cubicles and board rooms are out; open floor plans and multi-use spaces are in. Conventional office layouts are being revamped to become agile properties, such as coworking offices, business centers and serviced offices. The spaces cater to a variety of tenants, including start-ups, SMEs and, increasingly, larger organizations. Designs commonly boast a variety of onsite amenities and easy accessibility from nearby transit and housing centers.

The trend is more than just a cultural phenomenon—it’s having a meaningful effect on the market for office space: The number of coworking spaces in the U.S. has grown from less than 1,000 in 2010 to nearly 4,000 in 2018 as independent workers have grown to represent approximately 28% of the workforce. Looking ahead, flexible space offerings are estimated to account for 10% of Class A office space by 2028 and 30% of all office space by 2030.^[5]

5. How to get started

If you’re interested in investing directly in office real estate, Cadre provides accredited investors with access to institutional quality private real estate. To learn more about building your real estate portfolio or to become an investor, please request access to the Cadre platform.

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1. CBRE, CBRE Econometric Advisors, “How does the economic cycle influence the length of office leases?” February 27, 2017, https://www.cbre-ea.com/publications/deconstructing-cre-post/deconstructing-cre/2017/02/27/how-does-the-economic-cycle-influence-the-length-of-office-leases ↩︎

2. NCREIF, “Fourth Quarter 2018 NCREIF Indices Review,” February 7, 2018, https://www.ncreif.org/globalassets/public-site/webinar--education-page-images/webinars/webinar-slides-4q-2018-v-4.pdf ↩︎

3. Moody’s Analytics, U.S. Bureau of Labor Statistics, cited in Cushman & Wakefield, “Tech Cities 2.0,” September 27, 2018, http://www.cushmanwakefield.com/en/research-and-insight/2018/tech-cities-2 ↩︎

4. Cushman & Wakefield, “Tech Cities 2.0,” September 27, 2018, http://www.cushmanwakefield.com/en/research-and-insight/2018/tech-cities-2 ↩︎

5. JLL, “Coworking’s unstoppable market growth, https://www.us.jll.com/en/coworking-market-growth ↩︎

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