Why Private Cash Flow Investors Have a Hard Time Competing with Institutional Investors In The Office Market

I have been an owner and investor in office buildings for 35 years. I can tell you from experience that it is very difficult to generate consistent cash flow from office investments. Office buildings require large and consistent capital outlays for commissions, tenant improvements, and capital improvements. This fact is as true for creative office buildings as it is for traditional office buildings.  Office buildings have complicated HVAC systems, elevators, and roofs that require frequent reinvestment.  Competition and changing tastes causes frequent updating of common areas and even tenant suites.  Commissions need to be paid on every lease transaction. Tenant improvement monies need to be spent on almost every transaction, and they continue to grow. Tastes and space technology are in a process of constant change and require more capital investment.

Cap X will eat up over 300 basis points of your return over time. Most people I know who own office buildings make most of their return on the sale. Institutional owners have an advantage in the ownership of office buildings. First, institutional owners have more access to cash than private owners. Office building capital outlays require a constant source of cash–especially if you want to make cash distributions. Second, institutional owners look at the quarterly total return (including unrealized appreciation) and not just their quarterly cash return. In other words, institutional owners try to estimate their increase or decrease in asset value on a quarterly basis and publish a total return for the quarter. The investment managers will publish these returns for their institutional investors.  These institutional investors focus more on this quarterly total return estimate than the cash distributions, whereas cash flow investors focus heavily on the cash return.

Sometimes as a cash flow owner, we must choose to cash flow add versus value add. In other words, we may choose one tenant that will maximize our cash flow over the next five years versus one that will increase net value of the property on an appraisal basis.

You may ask about the fairness of these valuations. Barron’s recently did an expose on Brookfield, one of the largest office building owners in the World. The article was entitled “How Fair Are Brookfiled’s Values”, April 4 2016:   http://www.propertyprospects.com.au/investment-properties-for-sale/how-fair-are-brookfields-fair-value-estimates/

In a business that has many surprise cash requirements, the ability of institutional investors to offset cash returns with appraisal returns provides a big advantage at satisfying investor expectations during the operational phase of the investment.

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