A Space of One's Own

Do Office Condominiums Make Sense in the '90s?

Do suburban office condominiums have a future? With rising land prices in an increasingly competitive commercial real estate market, the outlook for these structures initially appears uncertain. But, given the right circumstances, they continue to be an attractive, viable option for some owner/users.

Suburban office condominiums became popular in the late 1970s as an alternative to renting space, offering a unique opportunity for small-business owners to own their office space. In the early 1980s, office condominiums became fertile ground for investors seeking new opportunities. This moved a step further when syndications began buying in.

Then, the Tax Reform Act of 1986 brought dramatic changes to the real estate investment market. Suddenly, the office condominium industry's largest source of capital was shut down as the real estate market headed south. Lenders were forced into an involuntary, more active form of ownership as many owner/investors began turning over their keys.

Almost overnight, life insurance companies and financial institutions were immediately forced to digest and value these assets. It wasn't long before the fire sales began. Entrepreneurial owners who bought in the late 1970s and early 1980s were crushed as they saw building values and rental rates plummet into the early 1990s. But as prices fell, savvy entrepreneurs began buying. Occupancy cost was a true bargain for the entrepreneurs who purchased their office space.

Today, resale prices are attractive to owner/users, and the prices are justified by realistic pro formas.

The Owner as Investor
At its inception, the office condominium concept was quickly embraced by the investment community. Investors learned they could purchase individual buildings or packages of buildings. In some cases, excitement about this new investment vehicle caused tunnel vision, as investors focused solely on the advantages and tax deductible benefits of depreciation, interest, and operating expenses. Some office condominiums would even deliver a positive cash flow.

Developers didn't have to look too far to find a site where the math would work. For instance, in metro Atlanta in 1979, office condominiums could be built for $55 to $60 per square foot including land costs. Over the next few years, small to medium-size business operators became more comfortable with the concept of owning their own office buildings as word of the buildings' advantages and offerings spread. With the upgraded amenities of fireplaces and lavish wet bars built into large offices and conference rooms, office condominiums became an easy sale.

Office condominiums also rapidly became a competitive vehicle to offset other income. The syndicators came in, and soon, tax-loss benefits became their primary selling tool. The formula even worked well in the inflationary early 1980s when the prime rate was close to 20 percent. Numerous investors were familiar with the concept; however, the pro formas often had discrepancies that meant future financial concerns. Rollover costs associated with filling vacant spaces, such as tenant improvements and commissions, were frequently overlooked on these 1980s pro formas that investors were buying. The pro formas also typically assumed annual building appreciation indefinitely.

Impact of 1986 Tax Reform
Then, the Tax Reform Act of 1986 changed the playing field for real estate investors. Most office properties could no longer benefit from accelerated depreciation-straight-line depreciation became the standard. Plus, the depreciation schedule was stretched from 19 years to 31.5 years. (This changed to 39 years in 1993 and issues regarding tenant improvements were amended in 1996.) Losses became strictly classified as either passive or active. Passive losses were defined as losses in which one did not materially participate in the management of the property, but also included all rental income/losses and could only be offset against other passive income. Earned ordinaryincome had to be offset by trade or business losses.

In addition, the 1986 tax reform eliminated the favorable tax treatment that capital gains had received. The tax shelter advantages of office condominiums for the owner as investor had been removed.

Subsequently, the effects of the act, together with changes in the real estate marketplace, affected the dynamics of real estate investment. The office market was being overbuilt in the mid-1980s in many metropolitan areas. Tenant incentive packages created a tremendously negative impact. "The killer was the free rent," according to Joel Griffin, chairman of the Griffin Company in Atlanta, and a pioneer in office condominium development. Landlords offered 14 to 15 months of rental abatement on the front end inside the term of five-year leases.

Office Condominiums Today
Office condominiums still make sense for the majority of owner/users who purchased them in the late 1970s and early 1980s and for some companies today.

But several issues have affected office condominiums in the 1990s, such as the Americans with Disabilities Act (ADA), which went into effect January 26, 1992, and the rising cost and complexities of acquiring land.

ADA has affected office condominium owners most visibly by creating the necessity for changing outdoor hardware, reviewing restroom situations-handles, lever faucets, grab bars, turning radii-and retrofitting entrances with alternative doors and ramps. At this point, the economic impact for office condominium owners has not been as great as originally feared because many major alterations are considered economically infeasible and thus are not required by the act.

Land prices are another hindrance to ownership. High prices have made it difficult for any new office condominium development in the suburban areas of major cities in the last few years. Also, in many markets, resales are still trading below replacement cost. Suburban office condominiums have a low site efficiency with only 10,000 to 12,000 square feet of building per acre. In 1979, suburban office condominiums in Atlanta were being developed for $55 to $60 per square foot inclusive of land costs. Today, the buildings would cost more than $100 per square foot-assuming one could find the land for $100,000 per acre.

Profile of the Owner as User
When office condominium development began in the 1970s, the office buildings were marketed to various types of businesses for general office purposes. Likely prospects included attorneys, accountants, real estate firms, travel agencies, sales offices, mortgage companies, counseling firms, and local entrepreneurs.

Office condominiums also have appealed to medical users (see sidebar). On average, medical users are very stable owners or tenants. They are more hesitant to relocate than general office users for several reasons, including the high cost of medical buildouts, which typically require extensive plumbing and insulation.

Pros and Cons of Ownership
The perceived benefits of office condominium ownership have made it easy for entrepreneurs to justify their decision to buy. These benefits include building equity, obtaining the tax benefits of sheltering other income and depreciation, eliminating the possibility of rental increases, and maintaining control over office occupancy and adjacent tenants.

Tangible benefits are augmented by the intangible benefit of the pride of ownership. Business owners can point to the building they own as a recognizable physical asset that builds credibility.

The disadvantages of owning one's office space include the upfront, out-of-pocket costs of the down payment, discount points, and closing costs. Other costs include ongoing repairs, capital improvements, and tenant defaults.

Some physical disadvantages of office condominiums include typically small floor plans that may require the company to locate on several floors. Further, the first floor often is partially below grade, with the disadvantage of fewer windows. The mechanical core and stairs often are located in the center of the floor plate, which can prevent a large open plan. Owner/users also risk outgrowing their building, and these buildings lack the flexibility of growing with their owners.

Another disadvantage can be characterized as the "hassle factor" involved in owning real estate, which can be minimized by enlisting a strong management company. Owners may choose to employ a management company or developer to handle everything from the financial management to leasing unused space in the buildings. Well-written condominium declarations and bylaws with clear and strictly enforced controls encourage a strong condominium association and help to preserve property values. In addition, strict signage and architectural controls enhance resale values. Office condominiums that are "owned in fee," where buildings can be purchased only in their entirety, seem to hold their value better than office condominiums in which individual suites may be purchased.

In addition, the various owners in a building must come to terms about issues such as maintenance and landscaping.

The Future
Suburban office condominiums possess several characteristics that are making developments succeed in the 1990s.

Recent downsizing in corporate America and changes in the dynamics of previously regulated industries have spawned record numbers of entrepreneurs and "gazelle companies." As the number of entrepreneurs grows, so will the need for small, efficient office space. Control and pride of ownership will continue to be important factors for entrepreneurs as tenants or as owner/users.

Over the next five years, office condominium resales will outnumber new development. The office condominium resale market should improve through normal market forces such as appreciation of the buildings, continuing the market trend of buildings trading at realistic pro forma-justified prices. "Pride of ownership" will always be a factor, and there are still several good ways to rationalize the buying decision in this market.

As for development, the high land basis will continue to be an obstacle for general office condominium development, and the high parking ratios will hurt medical development. However, some development activity in medical office condominiums is expected because of the medical user's stability and the reality that the cost of land is a lower percentage of the project's total cost because of higher medical buildout cost.

In conclusion, suburban office condominiums will not generally be attractive for investors, but they will continue to be viable investments for owner/users. Because resales will outpace new development, the office condominium market will tighten, contributing to increased values. Additionally, increased demand for small office space, coupled with pro formas that make resales attractive for owner/users, means that the value of these buildings will continue to improve.

R. Dale Lewis, CCIM

R. Dale Lewis, CCIM, is vice president of brokerage services at the Griffin Company in Atlanta. He specializes in representing office tenants and users. You can reach him at (770) 522-7400. Governor\'s Ridge Case Study The sale of the Governor\'s Ridge Office Park office condominium in the northwest Atlanta submarket in 1992 illustrates how these buildings made sense then and still work now for owner/users. The Williamsburg-style, three-story office condominium building has 5,760 total square feet. At the time of the sale, it was 67 percent occupied with five small tenants on the second and third floors. The 1,920 square-foot first floor is partially below grade and was available for a purchaser or new tenant. I represented the seller, a lender who had taken the property back from a Canadian investment group through foreclosure. The purchaser owned an obstetrics/gynecological practice and was represented by a broker. The doctor\'s office requirement was approximately 2,000 to 2,500 square feet, and handicap access was essential. The existing layout of the first floor consisted of two suites that had historically been extremely tough to lease because of the lack of windows; thiswas a plus for the medical practice. The challenge was confirming that the two suites could be combined into a floor plan that would accommodate all of the practice\'s needs. As with most medical buildouts, the improvement costs were very high-$31 per square foot. Our client, the bank, agreed to a sales price of $301,000 and $59,000 in tenant improvements for a total purchase price of $360,000 with a 10 percent down payment and a personal guarantee by the purchaser. The deal closed February 28, 1992. The pro forma shows the building\'s cash flows for year 1. The purchaser\'s cost of occupancy for the first floor was calculated by adding the principal and interest for year 1 ($32,628) to the operating expenses for year 1 ($26,335) for a total of $58,963. From this figure, we backed out the other tenants\' annual rent to determine that the purchaser is paying $9.57 per square foot for its medical space, a substantial discount over comparable leased medical space. There is no consideration in the pro forma for tenant improvements, downtime, or new commissions when a tenant vacates. The analysis also assumes an annual appreciation of 5 percent