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Owners of Class-B and -C Office Buildings Might Be Hardest Hit by the Pandemic. What Are Their Options for Moving Forward?

Mark Hefner, of MGO Realty Advisors, talks about how office investors can pivot successfully during the pandemic.

Amid the COVID-19 pandemic, class-B and -C office buildings are facing some big challenges as they tend to be occupied to a large extent by small businesses. These small businesses are less likely to recover from the economic impact of the health crisis.

A significant number of such businesses have already been forced to close their doors for good, while others have so far survived with a mix of government aid, forbearance on debt and rent and creativity in selling to an increasingly financially distressed populace, reports Reuters. But most firms have run out of the money secured from the $600 billion Paycheck Protection Program. Seventy-one percent have used the entire loan, while the other 29 percent are likely not far behind, according to a survey released this week by the National Federation of Independent Business, a trade group for small U.S. firms. Meanwhile the office market is suffering overall, with sharply spiking availability of sublease space in many markets. So, owners of class-B and class-C office buildings have to be creative in figuring out a way out of the crisis.

To get a handle on the potential strategies they can employ, NREI spoke with Mark Hefner, CEO of advisory firm MGO Realty Advisors, on the marketplace shift already underway and what owners of class-B and -C office buildings can do in order to survive the pandemic.

This Q&A has been edited for style and clarity.

NREI: What are some advantages and disadvantages of class-B and -C office buildings in the current market?

Mark Hefner: Users of space usually gravitate to class-B and -C buildings for economic reasons, aka lower base rent. What can happen, when that choice is made, is that fewer or lower quality services are delivered at the lower rent, so the tenants make compromises, sometimes unintentionally, that impact operations, morale and employee retention—all very costly indeed. The upside to this lower cost alternative can be greater influence on occupancy cost and services, so that the tenant drives what services are delivered and in what quality and frequency. If properly managed and delivered these leases can be of great benefit to the operation, and the bottom line. Another advantage to owners is that these buildings could be underdeveloped with vast, largely unused fields of parking that could be redeveloped to higher and better uses and unlock value for the owner.

NREI: How expensive is it to modernize class-B and -C office buildings? What are the most budget-friendly ways to do this?

Mark Hefner: This varies wildly! With historic low interest rates, landlords and owners/users with good credit and lender relationships are able to invest significantly to reposition buildings. We have recently been involved in an owner/user sale of a class-B office building in North California, where the buyer invested the same amount of money, about $4 million, into shell modernization and interior improvements as they did to buy the building. Another example is in Southern California, where we sold a 40,000-sq.-ft. vacant office building to a client for $275 per sq. ft., and they are investing another $85 per sq. ft. to renovate for themselves and other affiliated entities. That is very cost-effective modernization today, that includes new HVAC and roof. Those two examples provide you with a good cross section of market activity.

NREI: In addition to new and improved filtration systems, what are some other ways for owners to modernize class-B and -C office buildings to make them more desirable?

Mark Hefner: Before anything else, I recommend full and personal engagement with existing or departing tenants. While that sounds simple and automatic, many forces, including COVID-19, reliance on email, etc., at work in our lives, have caused landlords and tenants alike to be less personal and less meaningfully interactive. Questions like: “What changes can we make to your space or the building that would motivate you to renew and possibly expand?” and “What motivated you to leave, and what could we have done to keep your business?”

From that, and from being active in landlord and building management networks like NAIOP and BOMA, … even small-scale landlords [can become] current with best-in-class practices, from cost-effective fire, life, safety and HVAC systems upgrades to enhanced janitorial service and common area management. Somewhere within that personal interaction and best-in-class fact finding comes a cost- effective solution to tenant attraction and retention.

NREI: You’ve mentioned taking advantage of the major concessions in the market right now to us before. Can you explain this?

Mark Hefner: Credit tenants and even tenants that just pay their bills on time have supreme leverage today with landlords. We are advising our [tenant] clients to carefully evaluate their lease portfolios to determine where their real estate is out of alignment with their business plan. From there, develop an action plan to “right-size” the lease portfolio. Leverage can be deployed by extending some leases on mission-critical space and extracting favorable terms on rent, additional tenant improvement allowances and even receiving equity in buildings, should that align with the business plan or make good business sense. There may be a significant shift by some companies to go back to owning some of the real estate that houses their operations, because of declining prices and low interest rates. Lowering occupancy costs is the “new” mantra in board rooms around the world!

NREI: How should investors determine whether they should upgrade their building and continue utilizing it as office space or whether they should convert to another use?

Mark Hefner: Again, having a good and honest connection to existing and prospective users and tenants is the best barometer for making real estate investment or divestment decisions. We have a client with a 140,000-sq.-ft. vacancy in a large single-story building formerly used as office and data center space. That market is more active in industrial, and the building can support that use, both from zoning and the building shell. Should the owner gut the office improvements and pivot to delivering an industrial shell? We are securing offers from both industrial and office tenants so the investor can make a market-driven decision. Another good and recent example of different investment approaches on the same asset was the sale of an older office building with deferred maintenance in downtown Los Angeles. We represented the seller and created a competitive bidding environment between an owner/user and a developer who was building nearby. One was going to re-invest, while the other was going to demolish and add the land to a high-rise site. The developer won the competition.

NREI: Are there certain types of markets where these changes make the most sense?

Mark Hefner: Yes. Inner city buildings that have rising vacancies caused by the health and economic and social crises could be in a good position to pivot and embrace e-commerce [and] “last mile” tenants and other companies, public agencies and non-profit tenants with services that are in demand in those markets.

NREI: What is your estimated return on investment when it comes to either modernization or conversion?

Mark Hefner: Every investor has their own calculus, but most investors will not take this great risk or major investment without an intelligent proforma that suggests a 20+ percent ROI. Many investors holding onto cash are sitting on the sidelines for even more carnage and higher potential returns. But many investors who want or need to put money to work now are focusing efforts on Opportunity Zone real estate investments with good real estate fundamentals—to realize a twofold investment benefit.

NREI: Anything else you feel that office investors should consider in the current environment?

Mark Hefner: Like Houston in the 1980s, at what point does the owner of a vacant building that has not been modernized tear it down to save on property taxes and wait for a higher and better use?

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