Nationwide the vacancy rate for office space is 16.7%, plus or minus fifty basis points. Remember, a basis point or bip is 1/100th of one percent. Therefore fifty bps. (called 50 bips) is equal to one-half of one percent.
You are applying for a commercial loan, so you begin preparing a Pro Forma Operating Statement - an operating budget for the next twelve months. Your property is an average office building in the downtown area of an average U.S. city. Do you use as your Reserve for Vacancy and Collection Loss the national or city-wide average of 16.7%? Or do you use 5%? This is the subject of today's commercial real estate finance (CREF) training lesson.
A good argument can be made that office building investors in the U.S. are lousy capitalists. How could they allow 16.7% of their space to sit vacant? Capitalism says that they should lower their rent in order to attract enough tenants to fill their buildings. It makes good sense to lower their rent from $25 per square foot to $22 per square foot if they can fill the whopping 16.7% vacancy.
Let's do the math. C'mon, guys, this is fifth grade math. Stay awake. Let's assume that the office building has 100,000 net leasable square feet. If 83.3% of the space is leased at $25 per square foot, the office building generates $2,082,500 in gross rent. If all 100,000 sf was leased at $22 per square foot, the office building would generate $2,200,000 in gross rent. The owner picks up extra $117,500 by lowering his rent!
This brings up an important training point. Above I talked about rents of $25 or $22 per square foot. It is the customary in commercial real estate to talk about rental rates in annual terms. Therefore $25 per square foot works out to $2.08 per square foot per month. If you are renting 2,000 square feet for your property management company, you would be paying $4,160 per month in rent (2,000 sf. times $2.08 per square foot per month).
So why aren't office building owners better capitalists? For one reason, the higher the occupancy rate, the higher the operating expenses, such as common area heating, cooling, electricity, and wear and tear on the common areas.
There is another reason why office building owners don't lower their asking rents in order to fill their building. Suppose you own a mortgage company in the building, and you sign a lease at $25 per square foot. Then the owner starts advertising identical space for just $22 per square foot. Are you going to be a happy camper? Is your higher rental rate going to eat at you like an ulcer? And what is going to happen when your lease comes up for renewal?
But the most important reason why office building owners won't reduce their rents enough is that the lower asking rents will lower the value of their office buildings.
[Commercial mortgage brokers: You are making exactly 63 bonehead mistakes running your commercial mortgage brokerage. Bonehead mistakes. Sixty-three of them. I can fix you.]
How could increasing an office building's gross income possibly decrease the property's value? It has to do with the Pro Forma Operating Statement that will be prepared by the real estate broker representing the owner. When the selling broker prepares his Pro Forma Operating Statement, he will employ a concept called stabilized rent.
In theory, stabilized rent should represent the rental rate that would allow the entire building to find tenants. In real life, stabilized rent, as used by selling brokers, is the actual rent of any currently rented space, plus the possible rent that could be received if all of the vacant space was rented at the highest rental rate that the owner has ever received for any of his space.
Stabilized rent is an important concept, so please let me go over it one more time. The real estate broker or commercial mortgage broker is preparing a Pro Forma Operating Statement in preparation of either selling the property or refinancing it. He has prepared a Schedule of Leases that shows the existing tenants. But what does he do about the vacant units?
If he is one of my students, and he has read my blog article about getting the largest possible commercial loan (it received the most Linked-In likes I've received in two years), he uses the market rent of any vacant unit. But what is the market rent of this vacant office space? In truth, its $22 per square foot; but some idiot owner of a commercial mortgage company once paid $25 per square foot (sorry, but that was you). So the real estate broker uses $25 per square foot for the vacant space.
[Mortgage brokers: If you are not working every day towards building a loan servicing portfolio... get the hell out of the business! The only way to survive the next regular real estate crash is to fall back on your loan servicing income. The easiest way to build a servicing portfolio is to become as hard money lender. I service a $55 million portfolio at 1.9% annually. That's $87,000 every month, whether I close a new loan or not.]
But what about commercial lenders? What if you are applying for a commercial loan? Are commercial lenders stupid enough to fall this stabilized rent concept. Why yes... yes they are. Ladies, please cover your ears. Why do dogs lick themselves? Because they can. Translation: In real life, almost all commercial lenders will allow you to get away with this stabilized rent nonsense.
So the question I posed at the beginning of this training article was this: Should you use 16.7% as the Reserve for Vacancy and Collection Loss when you are preparing a pro forma operating statement on an average office building in an average big city? No! You should use stabilized rent and a 5% Reserve for Vacancy and Collection Loss. Why? Because you can.
