Many real estate investors start out investing in a residential real estate, buying and selling single-family homes. But with experience, some investors eventually realize that commercial real estate offers a unique opportunity to earn passive income and build long-lasting wealth while investing in office buildings.
Office properties, in particular, are especially lucrative, for several reasons.
Office properties are known for a higher return on investment. Single-family homes average between one to four percent ROI, while commercial properties offer between six to 12 percent.
The risk from vacancies is also lower since there are several units instead of just one.
Due to the number of units, offices allow you to enjoy multiple streams of income with just one property. And because leases are longer than with residential properties, the income is reliable income that you can count on month after month.
Some office properties even boast a triple net lease, which means not only do you get a long lease with an investment grade tenant, but the tenant pays nearly all the expenses associated with the property. That means expenses like repairs and maintenance, landscaping, property taxes, insurance, even the roof can all be passed onto the tenant. Triple net leases are really the perfect way to earn a passive income with absolutely no hassles whatsoever.
Investing in offices isn’t for newbies. It requires a level of experience and willingness to take on a certain amount of risk, which not all investors are prepared to do.
Thus the pool of investors interested in a particular property will naturally be less, giving you more opportunity to land a great deal.
As stated earlier, office properties have longer leases than residential properties. Tenants of single-family homes sign lease for a year or so, while office tenants sign for anywhere between three and five years, and sometimes for as long as 15 years.
Not only does this increase cash flow, but it also increases the value of the property. If you’ve done your due diligence and made sure to accept an investment grade tenant – preferably grade A – then you’re set for the next few years with a guaranteed source of income.
Depreciation Tax Shelter
If you do it well, depreciation is a great way to make money without paying taxes – legally.
Depreciation is the wear and tear that occurs to a building and its fixtures as time passes. The IRS allows you, the owner, to reduce your tax bill by depreciating the value of the property over a set period of time. For residential properties, you can depreciate a property and its fixtures over 27.5 years; commercial property is a full 39 years.
Plus, you get to write off an additional five years for what is called chattel depreciation, or the movable property located within the building.
Greater Value-Add Potential
Residential properties are valued according to the appraised value of the property. While there is a certain amount you can do to raise the value of a single-family property, the actual value will depend largely on factors out of your control.
Office buildings, on the other hand, get their value from several factors, such as leases, income, and tenant type. That means there is plenty you can do increase the value of a particular property. If you put higher quality tenants in the building, for example, the value will go up. On the other hand, if the building loses tenants, its value will go down.
Types Of Office Buildings
There are several types of office buildings, based on height, use, and quality.
Types of Office Buildings Based On Height
- High-rises: Skyscrapers
- Mid-rise: 3-10 floors
- Low-rise: 1-3 floors
Types of Office Buildings Based On Use
- Government – Houses government offices
- Medical – Medical office buildings usually fall into two separate categories: Class A, Class B, or standalone.
Class A medical office buildings are the newest types of office buildings and were developed specifically for a particular hospital. They are located next to the hospital or a large clinic.
Class B MOB’s may be owned by an investor, a group of physicians, or a hospital. Low to mid-rise buildings, they are located on or very near a hospital or a healthcare center.
Most are near hospitals, nursing homes, or medical centers, and cater to doctors or other types of healthcare tenants.
Stand-alones are smaller properties owned by physicians, built to accommodate a group of practices.
Research and Development (R&D)
Research and development buildings are industrial buildings with a mix of office space and warehouse, high-tech, or research and development space.
This type of property is similar to residential condominiums in that units are individually owned with public spaces shared between all tenants.
Types of Office Buildings Based On Quality
These are prime properties whose rents are higher than the average for the area they are located in. Tenants are industrial grade tenants who are comfortable paying premium prices in exchange for state-of-the-art systems, newly constructed buildings, and top-notch amenities.
Class A properties are located in the middle of a city’s business district and are often populated by real estate, law, and banking firms. Due to the popularity of the properties, tenant concessions are rare.
These properties are located in a less central location and are usually older than Class A. Tenants for these office properties are still stable tenants who during better times might have chosen Class A properties. Buildings are average to above average in terms of finishes and amenities.
Some Class B buildings actually started out as Class A buildings, and as a result of economic downturns or signs of wear and tear become visible, were downgraded. Others are in less than ideal locations, such as the suburbs.
Class C office buildings are aimed at tenants seeking lower prices. They are in the worst parts of a city and are of low quality due to the need for major repairs or renovations. Because of their age (more than 20 years old), building quality, and location, rents are at the lowest end of the scale.
Tenants rent out these properties because they are in need of commercial space and cannot afford a higher-priced property, and as a result, they tend to be very susceptible to the ups and downs of the economy.
Many Class C buildings are bought by investors in the hope of upgrading their status to Class B.
Factors That Affect The Success of Office Buildings
Although one-fifth of commercial properties are office buildings, they are still a property with a fair amount of risk. One reason why this is so is due to the fact that office buildings depend on the economy and level of job growth in the area.
The economy must be able to support a certain number of white-collar jobs in order for offices to thrive. If the economy is doing well, then companies tend to hire more workers and rent more space to accommodate new employees.
However, if the economy is in a downturn, then employees end up getting laid off, companies cut down on the amount of space they lease, and the resulting vacancies lower the value on your office property.
So if you’re considering investing in office buildings, you’ll first want to consider the state of the economy in the particular area you’re interested in.
These are indicated by interest rates, consumer and business confidence, and unemployment rates, to name a few. Demographics and local population growth are two factors that play an important role in determining where a specific location is in the market cycle; government plans for upgrading infrastructure such as transportation is another.
When demand goes up relative to supply, so do prices. That’s why the next thing you’ll analyze are supply levels. Find out what the vacancy and absorption rates are for the area, and get specific numbers on how much competitors are charging and what they offer their tenants.
One important thing to keep in mind is that office buildings lag behind the economy by about four to five months. Thus when buying or selling properties, you’ll want to keep this in mind.
Decide What Your Risk Tolerance Level Is
The type of office property you choose to invest in and the investment strategy you choose depend on your risk tolerance level and your investment goals. Every investment carries some risk, but the potential for return is directly related to the level of risk.
Obviously, you’ll need to do your due diligence to decide whether a particular property is risky or not, but you can quickly rule out properties by comparing the cap rate. A lower cap rate means the risk is lower, and you can expect steady returns over time. A higher cap rate, on the other hand, means higher risk as well as a higher possibility for returns.
Whatever you decide, start out by creating an investment plan that includes at least three exit strategies, and stick to the plan. Every purchase you consider should fit within the guidelines you set for yourself and with time and experience, you’ll eventually get the growth and returns you’re looking for.