Modelling Single-Tenant Office (non-NNN)
Hi all,

Relatively new to CRE, family office just beginning to explore opportunities. 

One asset type that we've been looking at is office complexes leased to a single tenant (or, largely - i.e., 75%+ leased to a single tenant with a few smaller tenants as well). The opportunities we've looked at have not been a typical STNL, however, and are generally credit tenants with between 5 and 10 years left on leases. Note that these are not NNN leases, but generally base year stop recovery structures; which coupled with the generally shorter lease terms we're seeing make me think that a lot of the advice out there to treat single tenant as a slightly riskier bond doesn't apply. 

My question for those of you with years more experience than I, is how do I model / evaluate an office complex that is almost entirely occupied by a single tenant, where the two possible outcomes at future renewal dates are so different? I.e., if in 5 years Tenant A renews, great, there are some leasing commissions possibly, and some TIs / free rent. However if they vacate, now we have 200K SF of office that was previously used by a single tenant - finding a new single tenant could take years, or to undertake a capital program to divide into  smaller units and lease those up to smaller tenants could also take place over the course of years. 

How do you guys generally view this type of investment, and any tips for presenting an "accurate" model / depiction of the possible outcomes?
[{"id": "fin6uur", "text": "It depends a lot on what your market looks like. In some markets (SF for instance) 200k of SF available to a single tenant would be exponentially more valuable than a 200k multi-tenant office building. However in more tertiary markets there is a risk of high TI costs, long periods of downtime, etc. that you\u2019ve identified. You could also look to sell to an owner user, which could be a third option.\n\nWhat I would do in your situation is model out both forecasts and sensitize them - I.e. weight the renewal probability what you think it would be and then weight the vacate probability. \n\nYou might not have access to Argus or need it for this property but if you do, this would be very easy to model out. Either way it is definitely doable in excel.\n\nEdit: I also want to add that base year stop is typically the most common office lease expense structure. Rarely do I see net office leases. So if you continue to look into office this will likely always be a modeling consideration.", "replies": [{"id": "fin7jkx", "text": "Thanks for the answer, I appreciate you taking the time. \n\n&gt;You might not have access to Argus or  need it for this property but if you do, this would be very easy to  model out. Either way it is definitely doable in excel.\n\nWe do have Argus and are using it for these. I think the struggle I have communicating to our ultimate decision makers is that the result of my modelling in Argus is say, an IRR of 10%, which is basically P(Renew)\\*$X + P(Vacate)\\*$Y; but we struggle with the fact that the eventual outcome is going to be a binary outcome, rather than the weighted outcome we are \"projecting\". Do you think that typically investors just require a higher return on these to accommodate for the inherent risk? \n\nAgain, appreciate the thoughts on this.", "replies": [{"id": "fin7wep", "text": "I think as long as you are realistic about the market leasing assumptions for the vacate scenario (interview brokers, look carefully at the market), the weighted average of the scenarios should implicitly account for that risk. \n\nIn how many years does the tenant roll?", "replies": [{"id": "fin89x0", "text": "One we're looking at with a tenant rolling in 5 years (has been there for over 20 years, always in 5 year lease increments). Blue chip tenant, probably a low probability of leaving, but it seems difficult to nail down those market leasing assumptions when there is a lot of variability in trying to re-lease / sell &gt;100k SF of office space (few comps, brokers don't have a ton of experience to draw upon, etc.). It's a great point, though. \n\nOthers we're looking at are closer to 10 years until they roll; those buildings are in CBDs, however, so it's more clear that we would likely break up the building in the future and lease to multiple tenants as there just wouldn't be demand for a single tenant we don't think.", "replies": [{"id": "finbab4", "text": "I don\u2019t think there\u2019s as much risk as you think given the background. That\u2019s good info to have. Plus, the risk of the major turn in 5 years has been in the history of the value/return expectations of the property - so it\u2019s not some huge disruptive risk. Theoretically the same scenario has been modeled out 4+ times.\n\n~10 year majority rolls can be tricky as you are likely buying a core/stabilized asset and need to start planning your anticipated hold period and exit strategy. Holding for 10+ years might be too long or you are trying to offload a building with a lot of turnover.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "finbx7r", "text": "I\u2019ve worked in Acquisitions for a healthcare REIT for the last 13+ years ($2.85 billion acquired, 125 transactions).\n\nYou absolutely must model multiple scenarios including one that the tenant vacates the entire building.   Under a scenario like that where you would be looking to backfill a large space, I would take the conservative approach and assume at least one year of downtime....of course that depends on your market.  If you\u2019re in San Fran, that probably isn\u2019t necessary.  You may want to get a subscription to Costar to look up market vacancies for that area.  In general, we underwrite to $7.5 per square foot per year for a TI allowance on a new lease (10 year lease term = $75 TI allowance) if the space is in shell condition (if it\u2019s an expensive market, you\u2019ll want to budget more) and $2.5 per square foot/year on a renewal.  Leasing commissions are generally 6% of the total rental revenue over the life of the lease and 4% on a renewal.  Call local leasing brokers in that market to get a better idea though as each market is a little different.  In Chicago for instance, they quote on a per square foot amount and Atlanta is typically equal to the first month of rent plus a percentage of the remaining rents revenue.   You should also budget one month of free rent for every year of lease term (10 year lease = 10 months free rent).  These aren\u2019t hard as fast rules but they would generally be on the conservative side for an initial underwriting pass through.   Also budget CapEx - a property condition report can help with that.\n\nLastly - CONDUCT TENANT INTERVIEWS WITH THE TENANT DURING DILIGENCE!!!   (Is that loud enough?).   Make sure that provision is included in the purchase and sale agreement for the DD period.    I can\u2019t tell you how many times I\u2019ve heard of buyers who bought a building and never conducted tenant interviews to find out the tenants thoughts on the building and then lo and behold, the tenant vacates when their lease is up.\n\nIf you have any questions, let me know.   My acquisition experience is limited to medical office buildings only. I\u2019ve never bought standard office buildings but the TI amounts are typically lower for office than medical office.", "replies": [{"id": "fio93h2", "text": "Thanks for the answer. \n\nRegarding the markets, we're close with a couple of brokers (not involved in the deals), who we are able to look to for some of these assumptions. And we will certainly model out the two scenarios - as I had mentioned elsewhere, we are using Argus so this is inherent in how it handles the assumptions. \n\nThanks for the rules of thumb re: TIs, leasing commissions and free rent. I've heard similar things, but that gives me a good benchmark to back up agains. \n\nWe will certainly be doing tenant interviews if we move forward and have a chance to perform diligence. We're still in the preliminary rounds of both of these, but that would 100% be one of our major tasks, along with tenant estoppels, etc.\n\nAgain, appreciate the input, it helps a newcomer like me hearing from those with lots of experience.", "replies": [], "depth": 2}], "depth": 1}]