Office building construction across the country has come to a screeching halt thanks to a mounting vacancy rate — 16.5% as of the second quarter, according to New York-based research firm Reis Inc. But multi-tenant space isn't the only game in town. Increasingly, developers are exploring the burgeoning office condo market where net annual returns can range anywhere between 15% and upwards of 40%.
There's plenty of demand for office condo product, too. Historically low interest rates have sparked buyer interest and drawn attention to the perks of owning vs. leasing. Condo ownership has the potential to offer big financial benefits over the long term. Not only do buyers deduct interest on mortgage payments, but they also acquire an asset that ideally will appreciate in value over time.
“The condos are a nice alternative in a softer leasing market,” says Brian Benninghoff, a partner at development firm Buchanan Partners.
Gaithersburg, Md.-based Buchanan built its first condo project in 2000 amid declining leasing activity. Buchanan traditionally focuses on land and building development that includes one-story commercial and mid-rise offices in the Northern Virginia and Maryland suburbs. But the success of that initial development has prompted the company to tackle three additional condo projects.
“Some would say that the demand for condos is being driven by low interest rates or pent-up demand that will eventually peter out,” Benninghoff says. But Buchanan Partners anticipates that condo demand will remain steady among small business owners who have fixed real estate needs and recognize the advantages of owning their own real estate.
Who's Buying?
Commercial condos function much the same as residential condos with buyers purchasing individual units, which typically range from 1,000 to 10,000 sq. ft. Some units, however, can measure upwards of 50,000 sq. ft. Condo buildings run the gamut, ranging from one-story office buildings fronting premier golf courses to downtown high-rises. The primary buyers are entrepreneurs and professional service firms such as doctors, dentists, accountants and other small business owners.
On the downside, there is always a certain amount of risk that comes with real estate ownership, and real estate in general is an illiquid asset. “The timing of when you need to dispose of an asset can be negative, because markets go in cycles,” says Jonathan Serko, an executive director at New York-based Cushman & Wakefield. In addition, condos are more suitable to businesses with fixed space needs. Conversely, they are not a good fit for firms that demand flexibility to expand or contract as their business changes.
Buchanan Partners built the 145,000 sq. ft. Cascades Business Center in 2000 in the Washington, D.C. suburb of Sterling, Va. Initially, Buchanan designed the building so that it could be either leased or sold. But with a slow leasing market, Buchanan opted to pursue condo sales. “We were surprised with how quickly they sold. Through that we realized how strong the commercial condo market was,” Benninghoff says.
Based on the success of Cascades, Buchanan started another project just west of Dulles International Airport. The 105,000 sq. ft. Dulles Trade Center I was completed last spring and is 80% sold. Buchanan also has broken ground on two additional condo buildings at the Dulles Trade Center that are 86,000 sq. ft. each. Both projects are slated for completion in the spring of 2004.
Roots of Popularity
Although newcomers such as Buchanan are just discovering the potential of condo development, veteran condo developers are well aware of the projects' rewards. The Griffin Co. in Atlanta, for example, has developed more than 1.5 million sq. ft. of office condo space throughout the Southeast since the 1980s.
“It became popular because people liked the idea of owning their own little office building,” says Joel Griffin, company chairman. As buyers become more sophisticated, they recognize that they don't necessarily need to own the whole building, he adds.
Griffin first introduced the office condo concept in a neighborhood-type suburban project with multiple small buildings, each about 4,000 to 6,000 sq. ft. Today, the firm delivers projects ranging from converted multi-tenant office buildings to newly constructed high-rise condos. Currently, Griffin is developing an 11-story, Class-A office condo building at the intersection of Peachtree Street and Palisades Road in Atlanta. Griffin expects to break ground on the $20 million, 145,000 sq. ft. building in the first quarter of 2004 with completion set for the first quarter of 2005.
One of the most aggressive condo developers in the country is Scottsdale, Ariz.-based Shea Commercial. The firm has developed about 500,000 sq. ft. of office condo space in Phoenix since 1999, and currently has 700,000 sq. ft. of office condos under construction in Maricopa County, Ariz.
Shea develops low-rise, garden office buildings that are about 10,000 to 12,000 sq. ft. and are split into two or three units with individual entrances. Construction costs range from $58 to $95 per sq. ft., depending on land costs and site work, notes Jim Riggs, principal of Shea. The condo units sell for $150 to $200 per sq. ft., an attractive fee for the developer considering that the price tag is just for the building shell. Tenants foot the bill for their own finishes, which typically run an additional $30 to $40 per sq. ft.
‘An Exploding Niche’
Traditionally, office condos represent a relatively small market niche. In Atlanta, for example, office condo space totals 9 million sq. ft. — about 7% of Atlanta's total multi-tenant office market that spans more than 126 million sq. ft., according to the Dorey Market Analysis Group in Atlanta.
Office condos are proving to be an increasingly hot commodity across the country. At Shea, for example, typically half of the units are sold before construction even starts.
“It has been an exploding niche,” says Donald Zeleznak, a salesperson with the residential firm of Keller Williams in Scottsdale, an investor and broker in office condo developments in the Phoenix area. Zeleznak is involved in about a dozen different condo deals representing both buyers and investors. “I think you have a large entrepreneurial base in the Phoenix/Scottsdale market where the professionals see a real advantage in owning vs. renting,” Zeleznak says.
The low cost of capital has certainly piqued interest in condo buying. “We have seen a resurgence in demand over the last couple of years because of the low interest rates,” acknowledges Griffin. Although the 10-year treasury yield, for example, has crept up from a low of 3.33% in June to 4.25% in mid-October, it is still at its lowest point since 1963.
Small tenants who have not benefited from the discounted rents that have surfaced in struggling office markets around the country also are driving interest in the office condo market. “Small users under 10,000 sq. ft. don't necessarily get the concessions that some of the big firms do,” Griffin says.
Office condo development is not all that different than multi-tenant construction. One distinction is that units need to be individually wired and metered for utilities and possess separate property identification numbers for tax purposes. Typically, a management association is in charge of property maintenance and upkeep, which provides owners with a property that functions much the same as any other multi-tenant building.
Small Business Owners' Perspective
The target group for condo ownership includes professional service firms such as Desert Mountain Family Dentistry. The company recently closed on a 1,600 sq. ft. condo at Shea's new Ironwood Office Suites in Scottsdale. “Condos are an up-and-coming idea that is favorable to small business owners,” says Stephen Itkoe, D.D.S, owner of Desert Mountain Family Dentistry. “It allows you to buy a piece of property without the expense of buying a piece of land and building your own building.”
Itkoe has been leasing the same space for 17 years, and will be moving about a block away to his new condo building when the tenant improvements are completed in early December. Itkoe opted to buy the condo as a means to establish fixed real estate costs and create a long-term investment.
Itkoe paid $284,000 for the shell, and he views the purchase as a good long-term investment for retirement, or a value-added asset if he decides to sell his practice. “The stock market is so crazy, but with this you're putting money into something that is a relatively stable investment,” he says. Riggs estimates that condos in the Phoenix area appreciate at a rate of about 4% to 6% per year.
Buyers such as Itkoe are being lured into condo ownership by incentives that include appreciation, tax benefits and control of the property. “Depending on what assumptions you use, a 10-year scenario of owning vs. leasing blows the socks off renting,” Griffin says. Cost savings on owning versus leasing on an after-tax basis over the long term can range from 25% to 50%.
For example, leasing a Class-A office space in the Buckhead submarket of Atlanta, based on current market conditions, can cost about $21 per sq. ft. gross. Factor in rent escalation over a 10-year period and the rate is closer to $24 per sq. ft., notes Marc Fritz, a senior vice president at Griffin.
In comparison, a firm buying one of Griffin's Buckhead condos would pay about $235 per sq. ft. Factor in components such as tax savings and the value an owner builds as the asset appreciates over time, and the net cost of owning over a 10-year period is about $12 to $13 per sq. ft. on an after-tax basis.
Competitive Obstacles
Although the returns sound attractive, office condo development presents challenges — one of the biggest of which is finding ideal locations. “Office condos don't work everywhere. The market conditions have to be right for it,” Riggs says.
Mature markets can be difficult because the volume of second- and third-generation office properties often creates an abundant supply of cheap leasing alternatives. Growing markets with a high concentration of target clients — professionals, service firms and entrepreneurs — are suited for office condos, Riggs notes. In addition to Phoenix, Shea has targeted markets such as Las Vegas and some of the growing suburbs in Chicago and Dallas.
Interest rates also tend to influence buyer demand. “The risk that we have is that if interest rates were to suddenly spike, it would take away what advantage we have over the rental market right now,” Griffin says. However, interest rates are so low that there is room for rates to move up 1% or 2% without rates impacting condo ownership's competitive advantage, he adds.
Others believe that the office condo market is less sensitive to interest-rate fluctuations than Griffin indicates. Back in the late 1980s and early 1990s, Riggs was selling office condos in New Jersey when interest rates were at 13%.
“I think the numbers still work when interest rates are as high as 9%, 10% and even 11%,” he says.
Interest rates are only a part of the lure of office condos, Riggs notes. Condo buyers are enticed by the package of benefits ownership provides, such as tax advantages, control of the property and the ability to create stable real estate payments rather than being subject to lease terminations and rent escalations.
Perhaps the biggest challenge is determining the depth of the condo market. “Office condos are not a niche. We see this product type in at least 10 states,” Riggs says. In Phoenix's Maricopa County alone, developers will build and sell over 1 million sq. ft. of office condos this year with 1.5 million sq. ft. planned next year. According to Riggs, “Every multi-tenant, multi-story office developer must consider this product type as direct competition to their leasing program.”
Beth Mattson-Teig is a Minneapolis-based writer.