Written by: Corey Janoff
Our office building is in a fantastic location. It’s in Southwest Portland, near the intersection of all the freeways coming into or out of the city. So no matter what part of town you live in, you’re within a 30-minute drive without traffic.
It’s outside of downtown, so finding parking is easy. We’re a short walk from the OHSU south waterfront campus, located along the Willamette River, with great views.
I have an unobstructed view of the river from my personal office space, with only a walking trail and some foliage separating our building from the water.
Purchasing Commercial Real Estate
In late 2019, a private equity real estate investment group purchased the almost fully leased Class A office building, with plans to spend a lot of money upgrading it into a premier spa, So out with the old owners and management team, in with the new. Talk about bad timing.
A few months after the acquisition, the whole world shut down, and the city of Portland implanted a mandatory work-from-home order for all businesses that could feasibly do so.
Unless you were a medical provider, there’s a good chance your office space was mostly empty for the majority of 2020 and the first half of 2021.
Some companies with expiring leases opted not to renew their office lease throughout the pandemic, as they learned that remote work functioned quite well for them. Other companies chose to downsize and move into a smaller space, opting for a hybrid strategy and allowing many of their employees to work remotely.
As I walk through our building today, I estimate that the offices are only 50% occupied. And I haven’t seen any tours of prospective new tenants. So if you’re looking for a new office space to rent, you have a lot of choices in our building!
Real Estate Maintenance and Renovations
The new ownership group is plowing ahead with their renovation plans to upgrade the building. We recently got new carpet on our floor, new recessed lighting, and a fresh coat of paint. In addition, the downstairs lobby and gym are going through a complete overhaul, which I’m sure will look fantastic when complete.
Supposedly they’re spending $6 million renovating the first floor and lobby alone!
One thing that’s quite annoying during the heat of summer is the air conditioning on our floor isn’t functioning properly. In talking with a gentleman in charge of maintenance in our building, he claims the previous ownership group did an awful job maintaining the building.
An example he gave me was out of the dozens of HVAC units in the building, only six of them had air filters in them. The rest have fans that are caked with dust and dirt.
As they go through cleaning and repairing one HVAC unit at a time, they keep finding more issues that need fixing. He had to beg and plead ownership to spend $750,000 to fix the HVAC system in the building (which they apparently get half of it back in tax credits).
Office Leasing Negotiations
In speaking with the woman who runs the café in the building and knows everyone, she claims the new ownership group isn’t budging on lease negotiations and demanding premium rent for what will ultimately be a premium space. As a result, more companies have opted not to renew their leases. And why would they renew?
Every office building in major metropolitan markets is half vacant right now. So you can walk down the street and take your pick of buildings and find a space that will suit your company.
I may be over exaggerating. According to Statista, the office vacancy rate in America is at 16.4% as of March 2021. That’s up from 9% at the end of 2019. I speculate many more offices are leased without tenants physically being there, waiting for leases to expire. I wouldn’t be surprised if that vacancy rate continues to creep higher as more companies elect not to renew their leases, opting for remote work instead. I could be wrong, of course.
Will the Gamble Pay Off?
The building is likely highly cash flow negative right now. They paid a premium for an almost fully leased building in late 2019 in a growing city as the economy was humming. They are proceeding with expensive renovation plans to increase rent on tenants and attracting companies who want a high-end space in SW Portland (when complete, it will likely be one of the nicest office spaces in the area that isn’t new construction, which there isn’t much of).
Current rental income is surely a lot less than their initial pro forma estimates suggested. In addition, maintenance expenses are likely greater than anticipated as they uncover more issues with the building.
This story could end one of two ways. Either demand for office space rebounds, or at least the demand for this particular building, and tenants return to physical offices. In that case, the initial investment will likely pay off in the long run.
Or, tenants will have the upper hand in lease negotiations if vacancy rates remain high and the building ownership group won’t be able to command the rent prices they want. As a result, profits will be considerably lower than initially projected. As a result, they’ll either have to meet the market price and/or sell the building at a loss.
Challenges of a Real Estate Investment
While a once in a 100-year pandemic is hard to predict, this story illustrates some of the challenges owners of real estate face.
There’s a large up-front cost to acquire real estate. Maintenance and upkeep are never-ending projects. You have headaches dealing with tenants. Sentiment and market demographics are hard to predict over time.
People who are enticed by owning real estate want to know how to become rich in real estate. But, unfortunately, a lot of it has to do with luck. You can run all the projections and crunch the numbers up and down, and odds are it won’t pan out as expected.
The outcome will either be better or worse than expected. So it’s best to ignore projected cashflow estimates because they’re almost always sure to be wrong.
Some Lessons Learned
1. Life rarely goes as expected. It’s tough to predict the future with consistent accuracy.
2. Have a healthy emergency reserve. Unexpected expenses pop up all the time. Ideally, you have some money set aside for them and continue to set money aside for future ones.
3. Have some slack in your finances. Income could go down. Expenses could increase. Be able to absorb it and take it in stride.
4. Don’t get too greedy. Of course, you must participate if you want any shot at realizing potential returns, but you don’t need the best returns to achieve your goals. Also, avoid over-leveraging yourself. Debt can be a personal finance killer if not used prudently.
5. Diversify. Most financial planners recommend putting no more than 5-10% of your money in a single asset. You never know which thing you own will perform well or poorly. Diversifying helps increase your surface area of luck and decrease the negative impact of an investment that doesn’t pan out.
When looking at purchasing any asset, ask yourself how that fits into your overall financial strategy. Will this help give you the best chance of achieving your financial goals?
This is a tricky question to answer, but it can help guide many of your money decisions. For example, should I pay down this debt or invest more for retirement? Should I put more money towards the kid's college accounts or set it aside for a future home down payment?
Doing your best to clarify your goals and objectives is helpful, along with diversifying.
Owning income-generating real estate properties can be a great component of a well-rounded financial strategy for those who have an interest in that. However, you can also create a superb financial strategy without owning any commercial real estate or rental properties.
To each their own.
Whatever you ultimately decide to pursue, do your due diligence and be sure as possible it aligns with your overall financial goals and objectives.
Related Blog Posts: