Recently, a 1.8 million square foot building in New York City was purchased for $600 million. That may not seem newsworthy except that the asking price prior to the sale was $1.74 billion. The drop in price could be attributed to a variety of factors, one of which may be that of the 1.6 million square feet available for rent, only half was actually occupied.
At first glance, a 65% reduction may seem like a steal, but a closer look reveals the true reasons behind the urgent need to sell. When such desperate measures are taken, the only logical conclusion is that there must be a reason. And that reason is what investors must investigate before succumbing to the lure of initial savings.
The New York City rental market is no different than other real estate market sectors. Vacancies are high and rents are declining. The subject property is 50% vacant. Given that fact, it is reasonable to presume that the property is generating an operating negative cash flow. Even if the property were bought for all cash, when you add back concessions, the property would be generating an operating negative cash flow. By any logical standard, any operating business with a negative cash flow is a failing business. In other words, the buyer spent $600 million for a failing office building business.
Because declines in real estate prices are so tempting, many investors find themselves in a scenario such as this. Once the property has been purchased, there are two options: fix it or sell it. Of course, selling it will result in a loss, but fixing it will require a large investment. But despite the overwhelming realization that the property is in trouble, it is often possible to rectify the situation. This will not be a simple task, but it may be worth the effort. If the goal is to rent 10% of the available space per year, the occupancy rate will increase from 50% to 95% in five years. Some of the items that must be addressed are updating the rental space and commission for leasing agents, not to mention the negative cash flow already in place.
During economic downturns, renters have the upper hand when it comes to negotiating conditions. This is apparent in the current average cost to the proprietor of $125 per square foot for remodeling. At this rate, which is calculated based on the New York City area, the owner would need to invest an additional $45 million dollars for improvements alone.
Not only do costs attributed to remodels and maintenance take a financial toll, but there are also certain fees and commissions associated with rental space. Agents charge fees of 5% to 6% of the lease amount to locate renters for the property. This fee must be paid up front. So at a 5% commission rate, the investor will pay about $3 million on a three-year lease at $50 per square foot.
What makes the negative cash flow fascinating is the impossibility of projecting other than losses will be large. The buyer only hopes that they are not larger than the money set aside to cover them. It will be in the millions per year. The bottom line is the buyer paid $600 million for a failing speculation. Assuming the economy cooperates and concessions aren’t a factor, what can the investor expect? Using the numbers above, and a 6% capitalization rate, the property could be worth approximately $750 million in five years. An interesting side note would be who received the leasing commissions, property management fees, insurance commissions, and capital improvement oversight fees? The real question then might be: Was it a good buy or a bad buy, and for whom?
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