Is it a Good Time to Consider Buying Your Office Space Instead of Leasing it?

With the high level of office vacancy sweeping the country, more brokers are saying that their clients are entertaining the idea of buying office buildings to accommodate their office space needs. A popular view currently holds that high vacancy is creating desperation in owners to get out of their investments by selling buildings at bargain prices. However, this view is far from the truth.

Prices across the country remain at historically high prices. The spread of value based on per square foot price versus the value based on rental anticipation is greater now than one year ago. Accordingly, the risk of ownership is growing while true value is becoming more uncertain.

This leads to the question of why tenants are so interested in buying instead of leasing. To start with, tenants and investors both comprehend that buildings sell for only half of the replacement cost. In San Francisco, for instance, the cost of the land plus building costs averages at least $500 per square foot. At present, office buildings sell for approximately $200 to $300 per square foot. Consequently, purchasing a building at half its replacement cost offers a strong appreciation in value over time.

Next, interest rates are at a record low and returns on investment are as well. Therefore, buildings selling at a 6 to 7 percent cap rate are regarded as good investments because of low interest rate return in other investments. Finally, tenants prefer investing in buildings over paying rent to a landlord. Current tenants view buying as a way to build their assets through real estate acquisition.

However, if an investor or owner/user fails to examine the future of rental rates and the high cost of maintaining a commercial property, they have difficulties handling their real estate investment. Instead, they should concentrate on the business that the investment was intended to house.

The current rental rates, particularly in mature markets like San Francisco, may continue in spite of any upturn in the economy. For instance, consider the last office leasing crash of 1986. For the next twelve years, with no development at all and throughout different positive and negative economic cycles, the city’s rental rate remained flat. The overall vacancy rates dropped over 6 percent, from 18 percent in 1986 to 12 percent in 1998. A variety of factors caused this phenomenon, including the advancement of technology, which reduced the need for office space.

Unfortunately, slow demand for office space over a long cycle does not relate to the leveling of construction, labor and marketing costs, along with the extra costs of new governmental regulations, such as life safety and ADA compliance costs.

Commercial property owners have far greater risks than residential owners because both the cost of vacancy and the cost to re-tenant are much higher. Owners who plan to occupy the building themselves and therefore not have tenants sometimes miss an important point. Upgrades are usually necessary to meet codes. These costs include basics, like painting and carpeting office space, and must be completed at the beginning of the purchase, during ownership or when the building is sold. But what happens when the owner’s space requirements change? They can’t leave the space for a better space before addressing a new issue. They are taking on the responsibilities of landlord, with all the uncertainties of the commercial rental market awaiting them.

Prudent tenants, who analyze the facts, will find that leasing space is a better solution than purchasing property. Rental rates have reached an historical low. By locking in to these rental rates now, they can end up with more money in their pockets, permitting them to invest in other real estate opportunities without risking their own business.