Office Building Appraisal
The predominant consideration in the development or purchase of an office building is its potential as an investment, and the participants in these markets are most concerned with earning a profit. The income characteristics of an office building form a complex and dynamic system that changes constantly over the course of the investment.
The complexity begins with the primary source of income for an office building, office leases. Leases for office space typically span several years, include a base rent that begins in the first year, and contain escalations. These escalations are sometimes based on a price index, such as a consumer price index or producer price index. Other office leases provide for the rent to step up by certain amounts at pre-defined times. Additional rent might include common area maintenance, or CAM, charges, which also might increase over time, either by contract or based on increases in the underlying expenses. These are pro-rated among the tenants. Finally, the leases often contain renewal options and these options can include additional escalation provisions.
Provisions also must be made for tenant improvements. Except for very small spaces, office space is typically leased in shell condition. The interior walls and doors, floor coverings, and ceilings are custom built to suit the needs of the tenant. If the building owner hires the contractor to complete these tenant improvements, they can sometimes charge the tenant a little more than the contractor charges them, thus reaping a bit of an additional profit.
It takes time to lease newly developed office space and as leases expire, if tenants do not choose to exercise renewal options or to sign new leases, it takes time to find new tenants for the space. This results in a loss of potential income due to vacancy. The magnitude of the vacancy loss is dependent on the local market for office space.
The demand for office space depends on the employment, and prospective growth in employment, in the industries that use office space. These include professional services, finance, insurance, and real estate. Employees at different levels within these industries use different amounts of office space. An estimate of future office employment in a market can provide a reliable estimate of the demand for office space. This can be offset against available office space in the market to provide an estimate of future vacancy.
It is also important to account for losses that will occur when tenants fail to pay their rent of fail to pay on time. This is a collection loss.
Many expenses are associated with operating and maintaining an office building. These include payroll for the staff, utilities, maintenance and repairs, management fees, leasing commissions, property taxes, and insurance. Furthermore, it is important to maintain a reserve for replacements so that building components can be replaced as they wear out. Some of these expenses are offset by any common area maintenance charged to the tenants, but many of these expenses will remain the responsibility of the building owner.
When the operating expenses are deducted from the gross income, what remains is the net operating income. This is capitalized to arrive at a professional estimate of value for the property. The capitalization process is accomplished with a capitalization rate.
There are two types of capitalization rates: direct overall capitalization rates and discount rates. A direct capitalization rates is the ratio of net operating income from a single year to a sale price and can be extracted from comparable sales. Discount rates are essentially the reciprocal of interest rates or rates of return and are derived from market rates of return available from comparable investments. Direct overall capitalization rates, discount rates, changes in net income over the course of time, and changes in the value of the underlying asset are all related to each other. A commercial real estate appraiser is an expert in these relationships.
A direct overall capitalization rate is used to convert a single-year’s net operating income into value by dividing the net operating income by the capitalization rate. The use of a discount rate involves multiplying the net income over a series of years by the discount factors for each of these years and adding the results.
Keeping track of all of all of this can be quite a task. For this reason, specialized software is often employed in arriving at a professional opinion of market value for office buildings.