Comcast Center is a 58-story office and retail development in the heart of Philadelphia’s downtown.
Office development is a critical component in the economic vitality of urban and suburban areas, with location and market conditions influencing the type of structure. Office users can vary widely in size, occupying spaces from 500 square feet (46.5 m2) to several million square feet.
This chapter focuses on office buildings most frequently built or retrofitted by beginning developers—costing under or around $10 million and ranging from 5,000 to 100,000 square feet (465-9,300 m2).
The increasing adoption of technology, sustainable practices, and the aftermath of the Great Recession along with its lasting effects create a new reality for all developers, especially those new in the field.
Office developments are categorized by class, building type, use and ownership, and location.
CLASS. The most basic feature of office space is its quality or class. The relative quality of a building is determined by a number of considerations, including age, location, finish materials, amenities, and tenant profile (see figure 5-1). Office space is generally divided into three major classes:
1. Class A—New highly efficient properties in prime locations with first-rate amenities and services, as well as older significantly renovated or upgraded buildings with prestigious or landmark status. They achieve the highest possible rents and sales prices in the market. Certain office developers acknowledge an A+ class for LEED-certified properties achieving 10 to 15 percent energy efficiency versus comparable buildings.1
2. Class B—Older, somewhat deteriorated buildings in good locations with finishes, amenities, and services that are lower than Class A. Newer properties might also be designated as Class B if they offer lesser services and amenities. They achieve lower rents and sales prices compared with Class A properties.
3. Class C—Facilities with inferior mechanical and building systems, below-average maintenance, and very limited services compared with Class B. Rents and sales prices are the lowest in the market and are often in less attractive locations than Class A or B buildings.
BUILDING TYPE. Four major office building types are widely used for categorizing purposes:
1. Typical Office—Single structure located in downtowns or suburbs with office use being the main revenue stream; possibly a minor retail component;
2. Mixed-Use Development (MXD)—One or more structures combining at least two significant revenue streams (for example, retail, office, residential); suburban MXDs cover more than 100 acres (40 ha) with buildings of various heights;
3. Garden Office—Low-rise structures clustered together in office parks with extensive landscaped areas; and
4. Flex Space—One- or two-story buildings usually located in business parks that facilitate an office component combined with space for light industrial or warehouse use.
BUILDING HEIGHT. Buildings are categorized by height as follows:
• High-Rise—Typically higher than 12 stories;
• Mid-Rise—Four or five to 11 or 12 stories; and
• Low-Rise—One to three or four stories.
The Council of Tall Buildings and Urban Habitat suggests that better indicators of building height designation are (1) height relative to context (comparison with other structures in the area and local zoning codes), (2) proportion (slenderness of the building against low urban backgrounds), and (3) tall building technologies (for example, vertical transport technologies).
USE AND OWNERSHIP. Office buildings can also be classified by their users and owners. Buildings can be single- or multiple-occupant structures. A single-occupant building may be leased from a landlord or owned by the tenant. In the latter case, it is referred to as an owner-occupied building. A building designed and constructed for a particular tenant that occupies most or all of the space is called a build-to-suit development. A single- or multiple-occupant building designed and developed without a commitment from a tenant is considered a speculative (spec) building.
Medical office space is often a unique product, designed specifically for doctors’ offices. It can be single-tenant or multiple-tenant space. It is often located in a campus setting near a hospital, or even on hospital grounds.
LOCATION. In most urban areas, at least four distinct types of office nodes can be found, distinguished by their location:
1. Central Business District (CBD)—High land costs in CBDs encourage more vertical development in the form of mid-rise and high-rise structures. Typical tenants in downtown offices include Fortune 500 companies, law firms, insurance companies, financial institutions, government, and other services that require high-quality prestigious space.2
2. Suburban Locations—Since the latter part of the 20th century, a decentralization trend has led to greater diversity in office locations outside the city center. Suburban nodes of large and small office buildings are often found in business districts, in clusters near freeway intersections, or in major suburban shopping centers. Rents are traditionally lower than the CBD and tenants include regional headquarters, high-tech and engineering firms, smaller companies, and service organizations that do not require a location in the CBD.
3. Neighborhood Offices—Small office buildings are frequently located away from the major nodes, where they serve the needs of local residents by providing space for service and professional businesses. Neighborhood offices can be integral parts of neighborhood shopping centers or freestanding buildings.
4. Business Parks—Business parks include several buildings accommodating a range of uses from light industrial to office. These developments vary from several acres to several hundred acres. Flex-space office buildings, with capabilities for laboratory space and limited warehouse space, are typically located in business parks.
In recent years, some developers and tenants have focused on dense urban transit-oriented locations rather than greenfield sites. Suburban areas are increasingly undesirable for certain companies and developers due to suburban sprawl, the resulting traffic, and the lack of public transportation. Substantial rent increases in suburban areas over the last 25 years have further increased the desirability of urban infill locations. However, companies interested in lower-cost space and labor, as well as build-to-suit facilities, will continue to find suburban locations attractive.3
The office market is a highly cyclical business that is subject to boom and bust periods. The playing field for office development comprises many elements, and unforeseen changes in basic forces can influence office markets in unexpected ways.
MARKET TRENDS. In the 1980s, significant increases in liquidity combined with investor and developer optimism on demand and rents led to significant overbuilding, causing substantial vacancies—around 20 percent—in the early 1990s. It took ten years of economic expansion with relatively little new office construction to decrease the national vacancy rate to around 10 percent—when 5 percent is considered the “normal” rate. Development started increasing when the 2001 recession (caused by the dot.com bubble and attacks of September 11, 2001) triggered employee layoffs and corporate cost cutting, leading to higher vacancies and lower rents. The short recession of 2001 was followed by the Great Recession, creating a financially frozen market (lack of debt and equity). Although the Great Recession ended in 2009 its effects remain into 2012, with vacancies hovering around 13 percent while development continues to face challenges. The lack of corporate reinvestment, anemic job growth, tight capital, and lack of credit market liquidity marginalize development. Regardless of project type, location, or leasing activity, construction loans remain difficult to obtain. In 2007–2008, the preleasing requirement for office buildings was 40 to 50 percent; by the summer of 2010, it increased to 75 percent, with an equity requirement of 20 to 30 percent and substantial guarantees.4
RECENT FINANCIAL TRENDS, CREDIT FREEZE, WORKOUTS. Several factors caused the credit freeze in commercial lending from 2008 through 2010:
• significant exposure of lenders to residential defaults/capital losses;
• a major shift of commercial bank asset portfolios to real estate (37 percent in 2007 compared with 25 percent before 2000);
• poor due diligence and underwriting standards (investors and capital providers overrelied on quality ratings by rating agencies, such as Moody’s, rather than in-depth due diligence, leading to significant suppression of cap rates from 2000 to 2006;
• a widespread lack of transparency in financial dealings and instruments; and
• a mismatch of duration between borrowing short and lending or investing long.
Two additional factors affected commercial property liquidity of suppliers, beyond bankers:
• perception of risk after the bust of the housing bubble and the possibility of a commercial bubble due to the continuing price increases; and
• international accounting standards (promoted by the Securities and Exchange Commission) requiring property owners/investors to identify the fair or true market values of their assets when computing their balance sheets.5
As a result of the Great Recession, a number of under-construction office projects required workouts. The approach used in each workout is different due to the parties involved, type of lender, problem, and reputation of the developer. Some insights are provided regarding some causes of project challenges during and after the Great Recession:
• Development participants were not conservative enough; they became increasingly greedy, in part due to market liquidity.
• Developers were significantly overleveraged, assuming they would refinance with improved terms or sell the asset for profit when the loan was due.
• Developers underestimated budget expenses, which were not finalized before construction.
• Developers’ capital structure was problematic with significant debt, minimal equity, and not enough preleasing.
• Permits were not secured and/or were delayed by local municipalities, adding to costs.6
FIGURE 5-1 | Characteristics Determining Office Classification
INFLUENCE OF TECHNOLOGY. Technology is the driving force behind increased efficiency and long-term cost savings. Technologies such as Building Information Modeling (BIM) can be applied in the design and construction process, as well as used in the building automation system (BAS). The BAS allows building managers and owners to monitor and create efficiencies in major building systems, such as heat exchangers, automatic dimmers, and OLEDs (organic light-emitting diodes), creating “smart” buildings with single rather than multiple network systems communicating through Internet protocol.
A developer’s budget, market conditions, and the type of tenant pursued will determine the most balanced approach regarding the applied technology innovations and the rent premium tenants will be willing to pay. Developers should also review the various incentives offered by local, state, and federal governments. An excellent source on renewable energy and energy-efficiency incentives is the Database of State Incentives for Renewable Energy (www.dsireusa.org/). DSIRE was established in 1995 by the U.S. Department of Energy
GREEN DEVELOPMENT. The two most popular green property designations are Energy Star,7 launched by a joint effort of the U.S. Environmental Protection Agency and the Department of Energy in 1992, and LEED,8 launched by the U.S. Green Building Council in 1998. LEED is designed around a point system, as shown in figure 5-2. The most recent LEED guidelines (Version 3.0) were released in 2009, with four relevant ratings for office buildings:
• LEED-NC (New Construction);
• LEED-CI (Commercial Interiors);
• LEED-CS (Core & Shell); and
• LEED-EBOM (Existing Buildings Operations & Maintenance).
Some developers consider Energy Star more meaningful than LEED because it emphasizes energy efficiency with a greater impact on the operating budget. LEED certification, however, can be accomplished with little or no financial premium if the building has modern systems and a curtain wall. Some driving forces behind LEED construction include a higher likelihood of obtaining bank financing with lower interest rates for construction and permanent loans; pension fund investment interest; and increasing preference among Fortune 500 and other companies with green mission statements.9
Developers and managers of both new and existing sustainable properties face certain financial challenges. From an operating budget standpoint, the upfront capital required for LEED certification might take more than three years to recapture, which can exceed the developer’s holding period. Further, the cost savings cannot be easily determined yet because of (1) the small number of LEED buildings with historical information, (2) a lack of documentation on the cost savings received separately by the tenants and the building, (3) minimal documentation on changes in employee satisfaction and health patterns, and (4) the disparity between who pays for most of the LEED certification and who reaps the benefits, with tenant participation in the cost still lagging.10 However, new and revised building codes are increasing the energy-efficiency requirements, thereby reducing the cost premiums to achieve LEED certification.
Research on the effect of sustainability on real estate is expanding. Eichholtz, Kok, and Quigley’s11 study of a group of green and nongreen comparable properties identifies a premium of 3 percent in rents and 16 percent in prices for the green properties. Fuerst and McAllister,12 as well as Miller, Spivey, and Florance,13 also found premiums among the green versus the nongreen group of properties. A study by Dermisi14 of the spatial distribution patterns of LEED ratings and certification levels across the United States suggests aggregations in certain areas with certification levels affecting the total assessed values of office properties.
SUBURBAN VERSUS URBAN. The dispersed and low-density nature of most suburban offices causes transportation challenges. Despite certain large companies (such as Apple and Cisco) continuing to locate in sprawling suburban areas, developers are also noticing that companies targeting a young, highly compensated and/or specialized workforce are more likely to be located downtown or close to a transit line. Beginning developers should consider opportunities in urban infill developments that are ripe for redevelopment, assuming they are financially feasible and the complex permitting and approval processes and codes are understood.
CORPORATE CAMPUSES. A countertrend to the move back to the city has been the move of major corporations into corporate campuses. During the 1990s, for example, Sears vacated its namesake tower in Chicago and relocated to a suburban campus. In Kansas City, Sprint has created a new 240-acre (97 ha) headquarters campus in the suburb of Overland Park. USAToday’s headquarters moved from a high-rise tower close to downtown Washington, D.C., to a campus in suburban Virginia.
Some technology companies are embracing green corporate campuses, such as Google’s headquarters in Mountain View, California. Google’s facilities are built with sustainable materials and are designed to maximize fresh air ventilation and daylight penetration. All rooftops are covered with solar panels, while biodiesel shuttle service is available to all employees from the Bay Area. Points for charitable donations are provided to those who use other green transportation means, such as biking or walking. The campus also has plug-in vehicles and multiple bikes for intercampus movement.15
The first task for developers is to conduct a market analysis, a critical assessment tool for any successful project, to determine whether a market exists for additional office space. It also provides direction for site selection and design by indicating the type of space and amenities that office users are looking for. The market analysis also provides critical input for the financial analysis, which will ultimately be used to demonstrate the feasibility of the project and to provide investors and lenders with the information they need to fund the project (see figure 5-3).
Market analysis requires a combination of data sources and usually the assistance of a market research firm, although the developer should be sufficiently familiar with the market to make an initial determination of whether the project is likely to be feasible. Brokerage firms can be a source of major tenant information, leasing activity, and overall market trends. These firms also know what the current trends in the market are and what segments of the market have the largest unmet demand.
The market analysis is a study of demand and supply, which ultimately determine vacancy rates, rents, cap rates, and property values. It should survey the economic base of the local metropolitan area, including existing employers and industries and their potential for growth. It should also identify whether the market contains headquarters, regional, or branch offices. The type of tenant to be targeted will affect the design with respect to office depths, parking, amenities, and level of finish.
Developers should keep in mind that companies seek new space for several primary reasons:
• to accommodate additional employees or a new subsidiary;
• to expand an existing business;
• to improve the quality of their office environment;
• to consolidate dispersed activities into a single space; and
• to improve their corporate image (thereby improving both sales and customer contacts and enhancing employees’ morale).
FIGURE 5-2 | Office-Related LEED Ratings and Certification Levels for Office Buildings
DEMAND. The first step in any market study is to define the area of competition in the submarkets and in the region. For regional employment, a step-down approach can be used to allocate employment growth from the region to the local market. Office buildings compete most closely with other buildings in the immediate vicinity. Rents, amenities, parking, and services can vary considerably among submarkets, though regional conditions affect all submarkets. It is therefore important to understand how a particular development will address its competitive environment. The analysis of the metropolitan economic base involves studying existing employers and industries in the market and their growth potential, with particular focus on the sectors of the economy that generate demand for office space.
Projected employment growth is the key driver of office space demand. It includes new and expanding firms in the area, broken down by industry, ultimately yielding office-based employment growth projections for the local economy. Local employment projections are available from commercial brokerage companies as well as local governments and chambers of commerce. When an area’s projected office employment is available, the following equation can be used to estimate the total square footage demanded:
Projected office space demand =
Number of projected office employees
× Gross space per employee
If area employment projections are not available, the following formula can be applied to determine the annual demand in square feet (see figure 5-4):
Office employment demand of industryi =
Change in employment of industryi in the last two years
× Office share of industry,
Annual office demand in square feet for industryi =
Office employment demand of industryi
× Area’s gross space per employee
where i represents a specific industry
that drives office demand.
FIGURE 5-3 | Market Analysis Data and Sources
The annual office demand in past years is then used to project future trends of more than ten years.
Two good resources for the amount of space required per employee are Building Owners and Managers Association (BOMA) International’s Experience Exchange Report and the Institute of Real Estate Management’s (IREM’s) Income/Expense Analysis: Office Buildings Report.
The demand for space is also affected by market rents and tenants overleasing when space is readily available and rents are relatively low. Over time, office space per employee has tended to decline.
Users’ space requirements inevitably affect the design and type of facility, including average floor area, number of entrances, and the location of hallways and elevator cores. The bay depth—the distance between the glass line and the building core—is particularly important. Large users frequently desire large bay depths, but small users require smaller bay depths to increase the proportion of window offices. Space requirements are influenced by a potential tenant’s mix; 200 to 250 square feet (18.5–23 m2) per employee is now considered the norm due to the elimination of file cabinets and improved space efficiency, but space requirements per employee can vary greatly. Office cubicles can range from 6 by 6 feet (1.8 by 1.8 m) to 8 by 8 feet (2.4 by 2.4 m), while the physical office room space in most offices is 10 by 12 feet (3 by 3.6 m) or 10 by 15 feet (3 by 4.5 m). Although spaces are tight, they can become tighter if workers lack individual privacy, with more conference and phone rooms.16
Other critical components of the demand analysis include the determination of the annual net absorption, the obsolete space, and the net rentable square footage demanded per year. Net absorption represents the net change in the amount of occupied space in the market. Obsolete space could be replaced by new Class A space. All Class C space older than 50 years will likely be replaced within the next 20 years at a rate of 5 percent per year.
SUPPLY. After establishing market demand, the analysis should focus on the competitive supply within the market. The supply information gathered provides the basis for estimating rents, concessions, design features, desired amenities, and finishes. The key elements of the supply analysis are an inventory of existing competitive buildings within the market area and projects under construction and in planning stages. An inventory of competitive buildings should include the following information:
• location;
• gross and net building area;
• scheduled rent per square foot per month;
• lease terms;
• tenant finish allowances;
• building services;
• amount of parking provided and parking charges (if applicable);
• building and surrounding area amenities (restaurants, conference facilities, health clubs, and so forth); and
• list of tenants and contact people.
This information provides the basis for estimating rents, concessions, design features, and desired amenities. The market area for supply should take into account regional and metropolitan supply. The submarket definition—areas that include the primary competitors for the subject project—is especially important. All competitive buildings in this area should be carefully documented.
The analyst should determine total existing supply plus the future supply of office space. By subtracting the expected supply from the expected demand for office space, the deficit or surplus of office space for a particular period can be determined. This knowledge allows the developer to estimate the market conditions that will prevail when the proposed building comes online. Vacancy levels are an important part of the supply calculation and vacancy trends can indicate changes in demand. If demand is increasing faster than supply, vacancy rates should be falling, creating a more favorable market for the developer. Alternatively, if supply is increasing faster than demand, vacancy rates should be increasing. The vacancy rate resulting from turnover, sometimes referred to as the natural or stabilized vacancy, is inevitable.
FIGURE 5-4 | Use of the Annual Office Space Demand Formula by Industry
The absorption time, in months, of all the vacant space can be calculated as
where t represents the quarter or year the estimates takes place and t-1 the previous period.17
For an application of the AT equation, assume that the area of interest has 600,000 square feet (55,700 m2) under construction, with a vacancy of 1.5 million square feet (139,000 m2) and a net absorption of 1 million square feet (93,000 m2), and will require a 25-month absorption period. The AT equation assumes that the rate of new demand growth continues as indicated by the net absorption rate and that there is no new construction in the market other than what has already been started. No firm guidelines exist for determining what constitutes a soft market, although a market with fewer than 12 months of inventory is considered a strong market, 12 to 24 months a normal market, and more than 24 months (18 months in slower-growing areas) a soft market.
A common mistake is to assume that a proposed project will capture an unrealistically large share of the entire market. Developers should have sufficient cash available to cover situations in which leasing takes longer than expected, which can be influenced by such factors as timing of the project delivery, amenities, rent levels, and especially market conditions.
SUBLEASED SPACE. It is important to recognize subleased space in assessing supply because, although technically leased, it is often available, formally or informally, and is thus part of the market competition.
In the late 1990s, some firms engaged in defensive leasing to ensure their future ability to expand in prime locations. But when their growth plans did not materialize, they were forced to sublet the space.18 In markets where vacancy rates are low, if unanticipated subleased space and new product come online simultaneously vacancy rates can soar. Recent economic downturns have led to the availability of large blocks of subleased space.
SHADOW SPACE. Vicky Noonan of Tishman Speyer defines shadow space as “a leased space for which a tenant pays rent but it is vacant or not fully occupied and it is not yet available for sublease.”19 It is a potential threat to a building’s rental stability and market recovery during a down cycle because an increase indicates tenant contraction, which can eventually increase vacancy if the trend continues. The presence of shadow space is inefficient for a landlord because it cannot be considered stable income and the space could be offered on the market with a better return. Unfortunately, none of the published data sources track shadow space, and developers can only assess it by talking to area property managers. A rule of thumb in estimating the extent of the shadow space in suburban properties is to look at the building’s parking lot. If a building occupancy rate is more than 90 percent, but there are consistently plenty of available parking spots, it is an indication of possible shadow space.
EFFECTIVE RENTAL RATES. An important distinction in office market analysis is the difference between quoted (face) rents and effective rents. Property owners sometimes use incentives to maintain the appearance of certain rent levels while effectively reducing rent for certain times or tenants. Typically, lenders determine a specific rent and preleasing threshold as a condition of funding or for releasing of the developers’ personal guarantee on the construction loan. To meet these conditions in a soft market, developers may offer tenants concessions in the form of free rent for a specified period, an extra allowance for tenant improvements (TIs), or moving expenses, as long as the rent meets the lender’s requirements. The extent of the TIs is always market driven, with tenants pressuring landlords for more during periods of increased construction costs. Today, TIs are on average $5 to $6 per square foot ($54-$65/m2) per year of lease-term for Class A (for a ten-year deal, it is $50 to $60 per square foot [$540-$650/m2]) properties, while TIs for downtown new Class A buildings are $70 per square foot ($753/m2) and for Class B properties $30 to $50 per square foot ($323-$538/m2) for a seven-year lease. TIs for suburban office buildings are about $20 per square foot ($215/m2).20
Rental concessions are harder for market analysts to identify than asking rents because brokers tend to understate concessions due to the negative influence on their commission. Factors influencing the number and amount of concessions include tenant size, lease term, and tenant rating. Concessions remain common practice across markets, especially during economic down cycles, and lenders generally use effective rents in their analyses before funding a loan. In strong markets, building owners do not offer free rent, except perhaps during an initial period when tenant improvements are being completed.
The Studley Effective Rent Index provides in-depth analysis of major real estate markets for Class A office properties, including effective rental rates, concessions, and a breakdown of rent components (net rent, operating expenses, real estate taxes, and electricity).
Scheduled rental rate increases change the effective rent. For example, a lease with flat rent for ten years has a lower effective rate than a lease with annual 2 percent increases. A lease with annual 2 percent increases is likely to have a lower effective rate than a lease with annual increases tied to the consumer price index, because the CPI historically has increased more than 2 percent per year.
Calculation of Effective Office Rent
Suppose a developer has an office space of 1,000 square feet (93 m2) with a nominal rent of $24 per square foot ($258/m2) for five years. Concessions include six months of free rent and $3 per square foot ($32/m2) in extra tenant improvements. The developer’s discount rate is 12 percent. To find the effective rent, the developer must convert the lease and the free rent to present value, which can be computed per square foot.
GENERAL ADVICE ON OFFICE MARKET RESEARCH. When conducting office market research, developers should keep the following trends in mind:
• Tenants will continue to downsize and consolidate their office space in an effort to minimize their costs and improve their efficiency while reducing redundancy.
• Buildings with flexible floor plates are becoming increasingly attractive to tenants.
• Green, energy-saving, and energy-producing buildings are increasingly important for perspective tenants.
Allan Kotin of Kotin & Associates and the University of Southern California offers additional comments:
• The larger the tenant, the more difficult it is to determine what the tenant is actually paying in rent after taking into account rent concessions, such as free rent, expense caps, free parking, and extra tenant improvements.
• A problem with assessing the effect of larger tenants is their susceptibility to consolidations or changes in business plans from swings in the economy. Such actions can result in their putting large amounts of space on the sublease market.
• Major markets are stratified by scale as well as by quality, rent, and location. A 10 percent vacancy rate may be very misleading if the largest space available is only 20,000 square feet (1,860 m2). The market for 50,000-square-foot (4,650 m2) tenants is very different from that for 100,000-square-foot (9,300 m2) tenants.
• For major buildings, control of a single large tenant is far more important than generic measures of space.
• Despite the sophistication of market analysis, the fact remains that many small and medium firms decide where to rent space on such distinctly unscientific grounds as “where the boss lives.”21
Site selection is a crucial step in the project feasibility analysis because it directly affects the rent and occupancy levels. Developers should compare location, access, physical attributes, zoning, development potential, and rents and occupancy of comparable buildings and sites to identify potential opportunities and obstacles.
In general, office use can support the highest rents of any land use type and thus is often located on the highest-priced land. This factor should not deter developers because a high price is usually indicative of site desirability. Similarly, developers choosing sites based on a lower price can find themselves unable to compete in the market, even at lower rents.
The site should be able to accommodate an efficient building design. Office buildings are less flexible in size and shape than are most other development types. Floor plates (area per floor) are a key factor in a building’s suitability for a tenant. Those deviating significantly from 25,000 square feet (2,322 m2) require more than one building core due to the travel distance required of individuals. A second core substantially increases building costs because it requires additional stairwells, restrooms, and elevators).22 Developers should make sure that a larger structure will be in demand in the area. Small office users prefer buildings with floor sizes ranging from 16,000 to 20,000 square feet (1,500–1,860 m2), although smaller floor plates are not uncommon. The most efficient buildings are 100 feet wide and 200 feet long (30 by 60 m). Such a shape allows a core of about 20 by 100 feet (6 by 30 m) and a typical depth of around 40 feet (12 m) between the core and the exterior wall. Such plain rectangular boxes might be the most cost-effective, but prospective tenants may respond negatively depending on their type of business. For example, major law firms seek buildings that make a statement with their exterior facade and interior amenities, while call centers do not.
When land values are high, the cost of parking structures is often warranted, and parking structures are less flexible than buildings in their layout. Structured parking modules with efficient layouts should be designed in bays that are 60 to 65 feet (18–20 m) wide, with a minimum of two bays; therefore, a parking structure needs to be at least 180 feet (16.5 m) long to efficiently accommodate internal ramps.23
Topography can play an important role in site selection. Hilly sites may require extensive grading, which will increase construction costs, but they may also provide excellent opportunities for tuck-under parking that requires less excavation than a flat site.
Access is a primary consideration in site selection. Sites should have convenient access to the regional transportation system. Public transit options are important in urban locations. Developers should check the site’s highway and transit access with transportation authorities before proceeding, as well as the need for a traffic study.
Jim Goodell of Goodell Associates recommends that office buildings be located in areas with a sense of place. “A synergy exists between office buildings and activities such as restaurants, shopping, entertainment, hotels, and residential uses. A mixed-use environment generates benefits that translate into higher rents and better leasing.”24
Historically, office developers were concerned only with local zoning and building codes. Floor/area ratios (FARs), height limitations, building setbacks, and parking requirements were the primary determinants of how much space could be built on a particular site.
Today, communities often have wide discretion in reviewing projects not only for compliance with zoning but also for environmental and community impacts that are difficult to quantify. In some cases, specific impacts, such as increased traffic at a particular intersection, can be addressed by constructing offsite improvements, such as traffic signals or turn lanes. Others, such as increased regional congestion or lack of affordable housing, may be mitigated through the payment of impact fees.
Office developments generally have a positive fiscal effect by generating more in tax revenues than they require in public services. Shrinking local tax revenues from other sources have led many cities to look toward office development as a way to fund public projects and affordable housing, which has backfired in some cases, particularly when the economy weakens. For a time, San Francisco experienced an exodus of businesses from the city’s core when it instituted a combination of very high impact fees, exactions, and housing linkage programs.
Certain cities are in such distinctive and attractive locations that they can exact above-average concessions from developers, but even these cities have suffered a slowdown of new business development when the cost of their exactions made development unprofitable. Developers pass on the regulatory costs to future tenants in the form of rent or operating expenses and depending on the market conditions, tenants might seek space elsewhere.
Government bodies continuously revise local building codes covering building safety and public health, spurred in some cases by litigation or the threat of litigation. Many government agencies have also enacted stringent energy codes. This trend toward stricter building codes will likely continue.
ZONING AND LAND USE CONTROLS. In addition to the typical zoning restrictions on building setbacks, height, and site coverage, the regulations specifically affecting office development include FARs, building massing, solar shadows, and parking requirements. FAR is obtained by dividing the gross floor area of a building by the total site area. Some cities—Los Angeles, for example—have dramatically reduced allowable FARs, giving cities unusual leverage in negotiating with developers for facilities or services the city wants.
Some cities, including New York and Chicago, award FAR bonuses to developers that embrace sustainable development practices or provide public amenities in high-density commercial districts. For example, the FAR of One South Dearborn in Chicago, completed in 2005, increased from 16 to 21.27. The combination of a park in front of the building, the ground-floor retail, and the setback, which reveals the north elevation of the Inland Steel Building—a Chicago landmark—allowed for the additional credit.25
Most zoning ordinances include provisions that carefully define allowable building envelopes and shapes to stop buildings from casting permanent shadows, to prevent streets from becoming canyons, and to prevent the glass on buildings from reflecting excessive heat onto other structures. In addition, some government agencies regulate the types of materials, styles of architecture, locations of entries, and various other design aspects of office projects. Developers must recognize and work within these restrictions to determine the maximum envelope that their buildings can occupy.
One special regulatory device that has been used with urban office development is transferable development rights (TDRs). Although not widely adopted, TDRs allow for the sale of development rights on a property from one owner to another. If one owner wants to retain a two-story building on a site zoned for ten stories, that owner may sell the right to build the additional square footage to another landowner. Once sold, however, the original owner cannot build any more square footage than that for which zoning rights were retained. A number of obstacles exist in establishing a TDR (for example, allocating higher-density development, calibrating values for development rights, and creating a program that is simple to understand and administer but also fair). TDRs work well with historic landmark buildings because they might not take the fullest advantage of a site’s development potential. In addition, designation of older buildings as historic landmarks can complicate and even prevent major changes to their structure and exterior facade.
Parking requirements vary by location and building type, but they typically stipulate a minimum of three to four spaces per 1,000 square feet (95 m2) of rentable floor area. Developers often find that they must provide more spaces than required in order to secure financing. Communities wishing to encourage use of mass transit may however restrict the amount of parking. Some cities have also proposed mandatory off-site parking for some portion of the parking requirement for buildings in congested downtown areas. One concept that can satisfy local government’s desire to limit parking while providing the ability to meet tenants’ future needs is deferred parking. Deferred parking is shown on the approved development plan but need not be built until demand for parking is proved.
Local communities have also become increasingly concerned about the aesthetics of office developments. Although developers and their architects do not always appreciate the opinions of regulators, local planning staffs and officials are not shy about expressing their preferences about building massing and shape, exterior materials, and finishes.
JAS Worldwide International Headquarters is a renovation of three vacant, obsolete buildings in Atlanta. The amount of green space was increased through removal of unnecessary parking.
MIDCITY REAL ESTATE PARTNERS
TRANSPORTATION. A development’s traffic impact is a politically sensitive issue with congestion increasing beyond the central cities into the suburbs.
An increasing number of office developments are now required to provide a traffic impact study during the approval process due to the increased traffic loads in peak hours. Traffic mitigation measures can range from widening the streets in front of a building to adding a traffic signal or widening streets and intersections surrounding a site. Satisfying off-site infrastructure requirements can be extremely costly and time-consuming, not least because of the need to work with public agencies and other property owners.
An office developer may be required to undertake any of the following actions:
• restripe existing streets;
• add deceleration and acceleration lanes to a project; construct a median to control access;
• install signals at entrances to a project or at intersections affected by the project;
• widen streets in front of a project or between a project and major highways or freeways;
• build a new street between a project and a major highway; or
• contribute to construction of highway or freeway interchanges.
Instead of requiring certain improvements through exactions, some areas have created impact fee programs (assessed per peak trip generated or a fee per square foot) to cover traffic improvements. The number of expected peak trips generated by the project becomes a critical factor in the cost of the project because fees can be as high as several thousand dollars per peak trip generated. Peak traffic trips can be reduced by (1) adding a minor retail component to a project (a major retail component can possibly increase the traffic impact), (2) providing residential facilities on or adjacent to the site, and (3) providing links with public transportation systems.
Transportation demand management (TDM) programs (or transportation system management) have become a popular mechanism for reducing traffic. A number of cities require large projects to implement ride-sharing programs, such as car- or vanpools; to include reduced-price passes for public transit; and to provide preferential parking spaces for individuals who carpool. The developer is often responsible for ensuring the implementation of TDM programs because they are often a condition of approval. Commuting by bicycle or foot is another strategy some cities encourage while properties receive LEED points. In Boulder, Colorado, for instance, bicycle storage and showers for employees are a requirement for any office development, and good connections to the city’s network of bike trails are important for approval and marketing.
The financial feasibility process involves gathering market data from the market study, cost data for various alternatives, and financing costs and entering these data into the financial pro forma. Developers should also consult local mortgage brokers and lenders to determine current appraisal and underwriting criteria before considering a project.
Two useful sources for estimating local operating costs for office buildings are the Experience Exchange Report published by BOMA International and the income/expense Analysis for office Buildings published by IREM. Both reports are published annually with a detailed breakdown of operating costs and revenues for different types and sizes of office buildings across the United States. The Studley Effective Rent Index report is another source of aggregate operating cost information for Class A office properties in selected downtown and suburban areas.
The key to accurately estimating revenues for office projects is to make realistic projections regarding lease-up time, vacancy rates, and achievable rents. Developers can apply the SFFS (simple financial feasibility analysis) methodology outlined by Geltner and colleagues26 as an assessment tool for their go/no-go decision. Financing for Real Estate Development27 is also a good reference on financial feasibility.
Capitalization rates (cap rate = net operating income/property value) are very important in underwriting because a project’s debt capacity is a function of its value. Cap rates reflect variable market conditions over time, with low levels indicating a strong market versus high levels that indicate weak markets.
Developers should always be prepared for possible cap rate increases during construction and until stabilized occupancy is achieved for two reasons: (1) If the cap rates increase, the value of the property decreases and the lender can request the value difference from the developer, which can be substantial depending on the equity structure. If the developer cannot infuse equity or negotiate a deal, the lender can foreclose (worst case scenario). (2) Refinancing an asset in a period of increasing cap rates is difficult because of the additional equity infusion required by lenders.
The key to any successful design is to address the area market and building codes and offer an efficient building at an appropriate price. Among the major design decisions are the shape of the building, design modules, bay depths, type of exterior, and lobby design, all of which create an image and identity for the structure.
Office buildings also need to be adaptable and flexible to meet the shifting demands of tenants for periods spanning more than 50 years. Flexibility is especially important as tenants expand or contract. Tenants are very sensitive to the amount of common areas (for example, lobbies) in a building because they are typically charged for their prorated share of common space in addition to their usable space.
The market analysis should help provide the design parameters for the project, although some design elements, such as the placement of corridors, restrooms, stairwells, and fire walls, are usually dictated by local building and fire codes.
As a general rule, total project costs are broken down into the following percentages:
| Building shell and interior | 45% |
| Environmental and service systems | 25% |
| Land and site improvements | 18% |
| Fees, interest, and contingencies | 12% |
| Total | 100% |
A few comments can be made on the preceding project cost breakdown:
• The percentages differ depending on the project location (downtown versus suburbs), regional requirements, construction methods, and special fees required by local government bodies.
• There is pressure to improve environmental and service systems across the country while decreasing fees and contingencies.
• A rule of thumb is that in urban areas, the site improvements usually do not exceed 10 to 15 percent of total cost.28
• In high-rent districts, land is likely to represent a larger portion of the costs, as much of the increased rent can be attributed to the property’s locational advantages.
• In addition to the project costs above, developers usually expect a profit of between 20 and 25 percent. A profit of around 12 percent for developers will only cover operating costs without any overhead profit.
SHAPE. A square is the most cost-efficient building shape because it provides the most interior space for each foot of perimeter wall. But it often generates the lowest average revenue per square foot because tenants pay for floor area and windows. Rectangular and elongated shapes tend to offer higher rents per square foot but cost more to build because they provide more perimeter window space and shallower bays. Developers prefer rectangular buildings for multitenant speculative space because the interior and perimeter spaces can be more balanced.
Although nonrectangular shapes may be less efficient, they often create more interesting office shapes, more corner offices, and higher rents. Beyond the developer’s and architect’s vision, building shape is influenced by market conditions, environment, land uses, and zoning. In Asia, for example, there is a requirement that buildings avoid casting shadows, which leads to unique shapes and orientations.29
DESIGN MODULES AND BAY DEPTHS. Office buildings are designed using multiple modules, which allow for the repetition of structural and exterior skin materials. Although the design module is most visible on the exterior of the building, it should evolve from the types of interior spaces planned. The market study should suggest the types of interior design (for example, open-plan or executive offices) that are in the greatest demand in the target market.
The most common design module is the structural bay. Defined by the placement of the building’s structural columns, the structural bay is generally subdivided into modules of four or five feet (1.2 or 1.5 m) with the most common module being 4.5 to 5 feet (1.3–1.5 m), which provide a grid for coordinating interior partitions and window panels for the exterior curtain wall.30 In Europe and Asia, 3 feet 11 inches (1.2 m) and 5 feet (1.5 m) are the most common.31 The structural bay determines the spacing of windows, which in turn determine the possible locations of office partitions, ascertaining whether interior space can be easily partitioned into offices of eight, nine, ten, 12, or 15 feet (2.4, 2.7, 3, 3.6, or 4.6 m) (see figure 5-5).
Office width tends to respond to local market conditions, with the market analysis providing some guidelines. Typically, offices are 10 to 14 feet (3–4.3 m) deep, and hallways are five to six feet (1.5-1.8 m) wide. For example, private office space in Chicago is 10–15 feet (3–4.6 m) wide, whereas in Atlanta it is only 8–12 (2.4–3.6 m).32
The bay depth is typically 40 to 45 feet (12–13.7 m).33 Multitenant buildings with many small tenants require smaller bay depths—36 feet (11 m)—to permit a larger number of window offices. Institutional users, on the other hand, prefer 40- to 50-foot (12–15 m) bay depths, which are more efficient to build and tend to cost less. One alternative is an asymmetrical design, with the core offset to allow flexibility in marketing and layout. The bay might be 40 feet (12 m) deep on one side of the core and 50 to 60 feet (15–18 m) on the other.
Institutional users are more likely to prefer open-space plans, while design and media firms prefer exposed mechanical systems, open ceilings, and partition-free floor-to-ceiling spaces. Large bay depths offer an advantage in such a layout while providing greater flexibility in laying out workstations, whereas a few, if any, private offices require prime perimeter locations.
Developers should keep in mind that at least 12 percent of the floor plate will be occupied by mechanical equipment. And depending on the type of tenant and zoning allowances, the floor plate may increase to 20 percent.34
CEILING HEIGHTS. Floor-to-floor heights are typically between 11 and 14 feet (3.6–4.2 m). In areas where the height of the building is not constrained by zoning or other codes, Class A properties’ floor-to-floor heights may be 14.5 feet (4.4 m). In Asia, the most common heights are between 13 and 13.6 feet (3.9–4.1 m), while smaller concrete buildings—especially in Europe—are 12.4 feet (3.7 m).35
A building’s curb appeal is significantly influenced by its location on its site. Generally, a building should enjoy maximum exposure to major streets, and signage should be visible from those streets. Good site planning provides a logical progression from the street to the parking to the building’s entrance. The trip from the car to the entrance of the building gives visitors and prospective tenants their first impression of the building.
PARKING. In theory, an office building in which each employee occupies an average of 250 square feet (23 m2) needs four parking spaces per 1,000 square feet (95 m2), assuming that all employees drive separate cars. The typical area required for each car is 300 square feet (27.8 m2) for surface parking (which includes parking space and driveway) and up to 400 square feet (37 m2) for structured parking to include allowances for ramps.36 When workers carpool or take public transportation, the parking requirement is reduced. Specialty space, such as medical offices, generates more visitors and may increase the need for parking.
Lenders prefer at least four parking spaces per 1,000 square feet (95 m2) of rentable space, even though local zoning may require less. According to John Thomas of Ware Malcomb Architects, many developers reduce the parking ratio as a project becomes larger.37 For example, developers commonly provide four parking spaces per 1,000 square feet for the first 250,000 square feet (23,235 m2) but then provide only two parking spaces for each additional 1,000 square feet (95/m2). Experienced developers, however, cite inadequate parking as one of the most common flaws in attracting and holding tenants.
FIGURE 5-5 | Relationship of Module to Interior Office Size
For Gabe Reisner of WMA Engineers, the cost differential between below- and above-grade parking is not always substantial because parts of the below-grade structure can include mechanical systems, which will free a portion of leasable aboveground space. The cost of below-grade parking depends on the number of below-grade levels, water table elevation, and foundations for adjacent structures. According to Mike Sullivan of Cannon Design, the first level of a below-grade parking structure costs on average $30,000 per parking spot, but the cost doubles for each level below that.38
Some developers have presold their garage structures, raising a significant portion of the construction cost, while the cost to the tenants is a function of the market.
LANDSCAPING. Landscaping is critical to a project’s overall appearance and value. Landscape design can tie diverse buildings together, define spaces, and form walls, canopies, and floors. Concealing, revealing, modulating, directing, containing, and completing are all architectural uses for plants. Landscaping elements not only include vegetation—trees, shrubbery, ground covers, and seasonal color—but also rocks, streams, retaining walls, trellises, and paving materials. Landscaping may be used to control soil erosion, mitigate sound, remove air pollutants, control glare and reflection, and serve as a wind barrier.
Landscape costs must be assessed with the landscape architect during design. A reasonable landscape budget accounts for 1 to 2.5 percent of total project costs, although the cost might be much less in urban areas.
Preserving existing trees can improve a project’s image, assist with marketing efforts, and increase the project’s long-term value. Mature trees can easily be destroyed, however, if precautions are not taken during construction.
Exterior design concerns such aspects as exterior building materials, signs, and lighting. A building’s exterior design can be an invaluable marketing tool.
BUILDING MATERIALS. The building materials used are generally part of two distinct systems: the structural system and the skin system. The structural system supports the building, and the skin protects the interior space from the weather. An office building can be built using one of six structural systems:
• Metal Stud Frame—Generally used for one- to five-story buildings;
• Concrete Tilt-Up—Generally used on one- to three-story buildings and typically employed in flex buildings;
• Steel Frame with Precast Concrete (hollow-core planks)—Typically used for low-rise buildings;
• Reinforced Concrete—Used for both low- and high-rise buildings;
• Steel—Used for both low- and high-rise buildings; and
• Composite Structures (steel gravity framing with concrete core)—Used in high-rises and superstructures.39
The exterior of an office building can be covered with any number of materials:
• Exterior Insulation Finish System—Synthetic stucco formed in many shapes;
• Precast Concrete—Usually cast off site and shipped to the site and usually not part of the structural system;
• Tilt-Up Concrete Panels—Cast on site and used as part of the structural system, limited to three stories (most common in the suburbs, although panels have very limited utility in office buildings due to glazing limitations);
• Glass Curtain Wall System—A combination of vision and spandrel glass hung in front of the building frame (always used on Class A properties);
• Storefront System (two-story height limit);
• Metal Panels—Aluminum or steel finished in a factory;
• Stone—Granite, marble, or slate in large panels or small tiles; and
• Residential Materials—Including stucco and brick, used as exterior cladding materials and not as a wall system.40
Each structural system can be combined with another to produce economical hybrids, such as a masonry building with metal trusses or prestressed concrete floor units. Concrete tilt-up construction offers an advantage in that the concrete panels serve as both the structural system and the skin (see figure 5-6). Exterior materials can also be combined; for example, a tilt-up building might incorporate a storefront system or precast elements for architectural variety.
SIGNAGE. Signs identify a building and its tenants while creating an overall impression for visitors. Although tenants will negotiate for sign privileges, developers should retain sign approval as a condition in their tenants’ leases. Restrictions should stipulate the size, shape, color, height, materials, content, number, and location of all signs.
The developer’s architect should work with graphic and interior designers to create a signage program for individual tenants and for interior and exterior common areas. The best approach is to develop a comprehensive signage program that includes designs, materials, and color schemes for the following purposes:
• project identification at the entry to the development;
• building identification;
• directory of major occupants;
• directional signs for vehicular and pedestrian traffic;
• building location directories; and
• interior building service signs.
Some developers hire a single sign maker to coordinate the signs for an entire project allowing for expedited replacements and changes. The system for doorplates should allow for easy replacement of old signs when tenants change. Coordinating the installation of signs is the responsibility of the on-site building manager.
EXTERIOR LIGHTING. Exterior lighting can enhance the security of building entrances and parking lots and can highlight architectural and landscaping features. Inadequately illuminated areas may pose a liability problem. The developer should work with an electrical engineer and architect to design exterior lighting that will accomplish the desired effects while being energy efficient and easy to maintain. Mercury- or sodium-vapor, quartz, LED (light-emitting diode), and fluorescent lights are energy efficient and may be used in exterior lighting fixtures. Many jurisdictions have become concerned about light pollution, and they require the use of high-cutoff lights and limit the use of architectural illumination that lights the sky.
Lighting standards for parking lots should be placed around the perimeter of the lot or on the centerline of double rows of car stalls. The Illumination Engineering Society recommends a minimum illumination level of 0.5 to two foot-candles for outdoor parking areas and five foot-candles for structured parking.
The interior design must accommodate all the various systems—elevators; plumbing; heating, ventilation, and air conditioning (HVAC); lighting; wiring; and life safety—and provide a flexible core and shell, which are very important in attracting tenants. The use of modular systems (flexible walls or partitions) is increasing because of their flexibility to meet tenants’ changing needs.
Another boon to flexibility is the use of raised floors, which are typically four to six inches (100–150 mm) above the concrete slab,41 allowing data cabling, mechanical systems, and power to be configured easily. Even though they have an upfront cost, the operating cost savings over time, human comfort, and sustainability can outweigh the cost.
MEASURING SPACE. Multiple local and national measurement standards of office buildings exist (gross, rentable, and usable square feet), with BOMA International standards being widely used. There are three key measurements:
• Gross area is measured from the exterior walls of the building without any exclusion (basements, mechanical equipment floors, and penthouses).
• Rentable area is measured from the inside finish of the permanent outer walls of a building except vertical penetrations (elevators, stairs, equipment, shafts, and atriums). According to local definitions, it may also include elevator lobbies, toilet areas, and janitorial and equipment rooms.
• Usable area is measured from the inside finish of the outer walls to the inside finished surface of the office side of the public corridor. Usable area for full-floor tenants is measured to the building core and includes corridor space. An individual tenant’s usable area is measured to the center of partitions separating the tenant’s office from adjoining offices. Usable area excludes public hallways, elevator lobbies, and toilet facilities that open onto public hallways.
The tenant’s rentable area is derived by multiplying the usable area by the rentable/usable ratio (R/U ratio). The R/U ratio is the percentage of space that is not usable plus a pro rata share of the common area. For example, if a tenant rents 1,000 square feet of usable space in a building with a 1.15 R/U ratio, the tenant pays rent for 1,150 square feet:
Usable square feet × R/U = Rentable square feet
1,000 usable square feet × 1.15 = 1,150 rentable square feet
Tenants are very sensitive to the R/U ratio, often referred to as the building efficiency ratio, core factor, or load factor. The average R/U ratio for high-rise space is about 1.15. Low-rise space averages around 1.12. Developers with inefficient buildings (with R/U ratios greater than 1.2) sometimes arbitrarily reduce the ratio to make their buildings appear competitive. Developers should be careful to calculate pro forma project rental income on the actual rentable area and not on the gross building area, which is more appropriately used to estimate construction costs.
FIGURE 5-6 | Exterior Skin Materials
SPACE PLANNING. Effective space planning involves five basic components: the space itself, the users, their activities, future uses, and energy efficiency.
The amount of space and its functionality are controlled by a building’s exterior walls, floors, ceiling heights, column spacing and size, and the building core.
In a single-tenant building or a floor tenant, the tenant is responsible for improving the lobby and interior hallways. In a multitenant building, however, the developer improves the lobby, restrooms, and hallways that serve each suite, and individual tenants are responsible for their own suites.
Many modern office layouts use the open-space planning approach, which helps reduce the cost of initial construction and design changes. Partitions in open-space plans are movable, and a variety of furniture and wall systems are available that are attractive and use space efficiently.
An inviting lobby with an identity is critical in attracting perspective tenants even if it comes with a premium for the developer. Restrooms likewise can help recover high-quality decoration costs because both tenants and visitors use them.
ELEVATORS. Tenants’ and visitors’ initial impressions are shaped by a building’s lobby and the quality of the interior finish of elevator cabs. Finish materials used in the lobby—such as carpet, granite, marble, brass, and steel—can also be used effectively inside the elevator.
Elevator capacity depends on the kinds of tenants occupying the building. Buildings occupied by larger companies tend to need high-capacity elevators to accommodate peak-hour demand. Buildings with smaller companies tend to have lower peak-period demand because more tenants keep irregular hours; but professional tenants are more conscious of time lost waiting for elevators. Waiting time for elevators should average no more than 20 to 30 seconds; longer waits can affect a tenant’s lease renewal decision.
The following rules of thumb are useful for gauging elevator capacity:
• One elevator is needed per 40,000 square feet (3,700 m2).
• One elevator is needed for every 200 to 250 building occupants (for two- to three-story buildings the demand will be lower).42
• Buildings with two floors require one or two elevators, depending on the nature of the local market and the size of the floors.
• Buildings with three to five floors require two elevators.
• Ten-story buildings need four elevators.
• Twenty-story buildings need two banks of four elevators.
• Thirty-story buildings need two banks of eight elevators.
• Forty-story buildings need 20 elevators in three banks.
Many elevator control innovations are being used in high rises, such as kiosks where riders indicate the floor of preference and the system directs them to the faster elevator (grouping riders to various floors), significantly increasing the speed and capacity of the system.
Some very large office buildings—especially in downtowns of major cities—feature escalators in their main lobbies.
LIGHTING. Lighting plays a critical role in how users and visitors perceive the building. The 2007 adoption of the Energy Independence and Security Act meant the phasing out of incandescent bulbs between 2012 and 2014. Owners of existing buildings or developers retrofitting a property can benefit from the energy-efficient commercial buildings tax deduction, which can also be used to write off the indoor lighting retrofit cost.
Several types of artificial light are available for interior applications:
• Fluorescent—Fluorescent fixtures are expensive but have the advantage of long bulb life (18,000 to 20,000 hours) and reduced energy consumption. Under the 2007 energy legislation, T12 lamps will be replaced by more efficient T8 or T5 lamps.
• Light-Emitting Diode—LED fixtures are becoming increasingly common. LED bulbs have a long life (25,000 to 100,000 hours) and vastly reduced energy consumption.
• Incandescent—Incandescent fixtures are less costly than fluorescent fixtures but are more expensive to operate. They provide superior color rendering but a short bulb life (750 to 2,000 hours). They are scheduled to be phased out beginning in 2012.
• High-Intensity Discharge—High-intensity discharge lighting includes mercury-vapor (frequently used outdoors), metal-halide, and high- and low-pressure sodium lamps. Although they are excellent for illuminating outdoor spaces and are very energy efficient, high-intensity discharge lights offer poor color-rendering properties.
• High-Intensity Quartz—Sometimes called precise lighting, high-intensity quartz lighting is a new product that is often used in upscale environments. Multifaceted, mirrored backs reflect the light onto specific objects or areas, making high-intensity quartz fixtures appropriate for task-oriented lighting.
Office buildings use mainly direct lighting. Installed in a grid pattern across a dropped ceiling, this solution offers equal levels of illumination across large spaces. Direct lighting is available in integrated ceiling packages, including lighting, sprinklers, sound masking, and air distribution. Indirect lighting uses walls, ceilings, and room furnishings to reflect light from other surfaces. In recent years, indirect lighting has become common for general office lighting as a way to reduce glare on computer monitors. Indirect lighting generally requires higher ceilings to reduce “hot spots” on ceilings and to improve the overall efficiency of the lighting layout.
The electrical engineer, interior designer, and architect all play important roles in designing the lighting system to suit each tenant’s needs.
HEATING, VENTILATION, AND AIR CONDITIONING. A building’s HVAC system is one of the major line items in its construction and operation budget. Several different types of HVAC systems are available:
• Package Forced-Air Systems—These electrical heat pumps, usually located on the roof, heat and cool the air in the package unit, then deliver it through ducts to the appropriate areas of the building. The units are inexpensive to install and work well on one- and two-story buildings.
• Variable Air Volume Systems—A large unit on the roof cools the air and delivers it through large supply ducts to individual floors. Mixing units control the distribution of the air in each zone. This system offers great flexibility as many mixing units can be installed to create zones as small as an office, but it is more expensive to install than forced-air systems. The system allows for balance loads and automatically adjusts airflow. Rooms are heated by a heating element in the mixing units or by radiant heater panels in the ceiling.
• Hot- and Cold-Water Systems—A combination chiller and water heater is centrally located to provide hot and cold water to the various mixing units in the building. The air is heated or cooled in these mixing units and delivered to the local areas.
RBC Centre is a 43-story office tower in Toronto’s financial district. The development earned LEED Gold status and will produce an estimated 50 percent energy savings relative to the Canadian National Energy Code.
TOM ARBAN
The architect and mechanical engineer will provide guidance in the selection of the HVAC system. For a development of about 100,000 square feet (9,300 m2)—four to five stories of 25,000 square feet (2,300 m2) of floor plate—the most economical system is a rooftop variable air volume system, but in some markets heat-up systems are more common. LEED can be achieved with either. The capacity of the system will be determined by several factors, including climate, building design, and types of tenants.
The American Society of Heating, Refrigerating and Air-Conditioning Engineers (ASHRAE) publishes standards on the minimum ventilation rate for different occupancy and building types, relative humidity, and maximum allowable air velocity. Poor humidity control and leaks in a building can cause sick building syndrome, which exposes building owners to possible lawsuits. ASHRAE’s Humidity Control Design Guide for Commercial and institutional Buildings43 provides guidance on humidity control to the entire building team. The final authority on building ventilation is the local code authority, which may or may not have adopted ASHRAE standards. Standards for air movement and air conditioning depend on building design, climate, glazing, lighting, and building orientation.
Computer-controlled systems manage energy use of medium-sized or large buildings. A well-designed HVAC system divides the building into zones, each controlled by a thermostat. These zones should cover areas with similar characteristics, such as orientation to the sun, types of uses, and intensity of uses. A standard rule of thumb is one thermostat zone per 1,200 square feet (110 m2). Usually, each zone has one mixing damper that controls temperature by mixing hot and cold air.
TECHNOLOGY. Technology is changing the economics of office buildings in a variety of ways:
• Design—Building Integrated Modeling/Revit (BIM/Revit) is in the forefront of virtual coordination by facilitating complex design among mechanical, electrical, and plumbing systems. BIM allows the construction phasing to be better coordinated while providing a comprehensive data record for the operations management phase.
• Energy Sustainability—Buildings are consuming less energy with the help of low-E glass, external shading, automatic dimmers, and motion sensors. Some buildings are even producing energy with smart grid system and solar panels.
• Water Conservation and Reuse—Water system controls are becoming more sophisticated. Automatic faucets, low-flow toilets, rainwater harvesting, waterless urinals, and use of graywater for flushing toilets, landscape watering, and other nonpotable uses are increasingly part of the conservation effort.
• “Smart” Buildings—All building systems are integrated into one network, which allows the efficient control of life safety and security, building management, elevators, office telecommunication, and HVAC systems on site or remotely.
• New Revenue Sources—Every part of the office building is being examined for the potential to generate revenue. For example, income can be generated from communications towers mounted on roofs, from signage in highly visible locations, and from recycling waste materials, such as office paper.
• Maintenance Costs—Mechanical rooms are kept cleaner, with filters changed more often and air monitored. Recycling chutes in high-rise buildings eliminate the need for recycling bins on every floor.
ENERGY EFFICIENCY. A building’s energy efficiency depends on its site orientation, skin materials, window design, and types of mechanical equipment and energy control systems. Energy costs can decrease by investing up front in continuous building envelopes that do not provide thermal bridges. The energy efficiency of the exterior facade can be improved with active and passive shading systems and other thermal technologies, while harvesting rainwater and daylight. For example, a rain-screen wall is a pressure-equalized system with minimum operational maintenance cost, although there is an upfront cost.44
A popular way to measure energy efficiency is the U-value, which measure the rate of heat loss expressed in Btus per hour per square foot per degree difference between the interior and exterior temperatures. The U-value is the reciprocal of the total resistance of construction multiplied by a temperature or solar factor. As a general rule, U-values should be a minimum of 0.09 for insulated exterior walls and 0.05 for insulated roofs. The architect and mechanical engineer can provide recommendations for insulation.
Glass reflection plays an important role in determining energy use and is measured as the shading coefficient, which equals the amount of solar energy passing through glass divided by the total amount of solar rays hitting the glass. The lower the coefficient, the larger the amount of heat reflected away from the building’s interior. Lower shading coefficients tend to be more expensive to obtain and adversely affect the quality of light for building occupants. Many state and local government agencies have their own energy-efficiency requirements.
Numerous energy-related incentives are offered by government and nongovernment organizations. Two relatively new initiatives are the application of demand response mechanisms on buildings, which help manage energy use based on electricity grid supply conditions, and smart grid systems, which allow for two-way communication between consumers and utility companies. For Mike Munson of Metropolitan Energy, the smart grid system is simply a tool to transfer information.45 Smart grid systems enable building owners and managers/engineers to make better decisions about their building’s energy use. Munson notes that for new construction, the ability to optimize a building’s operational flexibility and to maximize the control of building systems with precision enables greater certainty and increases asset value by building control capabilities from the ground up. For existing buildings, the ability to acquire, process, and implement solutions using information provides for more discerning capital and efficiency improvement analyses.
GREEN BUILDING DESIGN. Green buildings can be defined in a variety of ways, but the U.S. Green Building Council’s LEED rating system has become the accepted standard. Green buildings accomplish reduced energy consumption by improving natural light penetration, using more efficient HVAC systems, and relying on more sustainable building materials.
Certain LEED points can be achieved inexpensively (for example, bicycle racks, showers, and transit subsidies), but long-term savings require the use of additional base building systems controls, such as heat exchangers, displacement air systems, double-wall systems, active shading systems, and so forth, which have an upfront premium. By adopting multilayered energy systems, the building can circulate air more effectively based on different situations and can synchronize electric lighting with daylight using lighting controls.
In cases where structures need to be demolished or rehabbed, disposing of the old materials in an environmentally friendly way can be difficult and costly. According to Tom McCaslin and John Wong of Tishman Construction Corporation, which built Four Times Square, New York City’s first green office tower, green buildings generally cost more to construct, although the initial cost can be recovered later through energy savings. A green building can also generate good publicity and promote the firm as environmentally friendly with some tenants willing to pay rental premiums.46 Four Time Square used several energy conservation features, including photovoltaic panels, fuel cells, gas-fired absorption units, and low-noise air handlers.47
SECURITY AND LIFE SAFETY. Life safety and security have become increasingly important in the design and marketing of an office building. The terrorist attacks of September 11, 2001, in the United States led to changes in access control and communications of major downtown office buildings. Protecting the building, its occupants, and its contents requires multiple security layers. A building has seven rings of defense:
• site perimeter;
• building standoff;
• building exterior;
• inner perimeter;
• building systems;
• screening and access control zones; and
• safe interior areas for valuable assets or personnel safe havens.48
The ability to control access in and out of a building is essential and can be accomplished by several methods, depending on such factors as the building’s location and setting, potential threats, tenant requirements, and so forth. During construction, developers need to consider the following:
• perimeter security measures;
• lobby security controls, including electronic monitors and security guards;
• access control card readers on parking and lobby entrances and elevators;
• an intercom system to a 24-hour remote operator;
• surveillance cameras in parking lots and in all egress and ingress points; and
• a lobby entrance for parking users, which might require installation of separate elevators.49
Life safety features include sprinkler systems, smoke detectors, fire hoses and extinguishers, and automatic shutoffs for the HVAC and public address systems. Developers should check with local authorities on fire codes because they differ by jurisdiction. Developers should keep in mind that adoption of various life safety systems (mandated or not by area building codes) can lower fire insurance rates.
As part of the lease, the developer usually provides a set allowance for tenant improvements that covers the buildout of the interior space. The allowance provides a minimum level of improvements, with the tenant financing the remaining space renovation. Because leases typically do not require the tenant to pay rent during the improvement phase, it is incumbent on the developer to ensure that work is done on schedule. Typically, TIs are $5 to $6 per square foot ($54-$65/ m2) per year of term for downtown Class A space (for a ten-year deal that would total $50 to $60 per square foot [$540-$650/m2]), but it can reach $70 per square foot ($753/m2).50
TENANT IMPROVEMENT PROCESS. Steps in the process of completing tenant improvements in a small office building parallel the steps involved in constructing the building itself: budgeting; preliminary planning, including design and construction drawings; approvals and permits; contractor selection and bidding; and construction.
• Step 1: Establish a Budget—The budget is determined by the quality the tenant wants and the resources available.
• Step 2: Prepare a Space Plan and Design for the Improvements—The space planner/interior designer may be under contract to the developer or to the tenant. If the designer is under contract to the developer, the developer maintains greater control but will be liable for all costs if the tenant backs out of the lease. The design firm is usually selected in one of two ways: (1) the developer selects a design firm and then recommends it to all tenants, or (2) the developer approves three or four firms and then allows tenants to select from the approved list.
• Step 3: Have Plans Approved—Plans are submitted to the local building department for approval and permits. Whenever improvements involve safety or require electrical work or partitions, building permits are required.
• Step 4: Select a Contractor—Generally, the developer selects a single contractor to do all the tenant improvements in the building, but some developers prefer to approve three or four contractors and then submit the drawings to each for bids. The developer usually works with the contractor to see that the bids are within the tenant’s budget.
• Step 5: Oversee Construction—The developer maintains close contact with the contractor during construction to ensure on-time and budget delivery. The developer should carefully monitor any claims for change orders so that the project remains within the tenant’s budget. All the parties will agree on the payment format before the construction begins.
WORK LETTERS. Work letters serve as the formal agreements between the developer and the tenant concerning the amount and quality of improvements that the landlord will provide. They specify the work the landlord will do before the lease commencement date, as well as the schedule of costs.
Building standard installation (the building standard) includes the list of items installed in every tenant suite: partitions; doors and hardware; size and pattern of acoustical ceiling tiles; floor coverings; size, shape, and location of lighting fixtures; electrical receptacles; switches; telephone and data outlets; plumbing connections; HVAC; painting and wall coverings; and window coverings or venetian blinds. If the tenant wants items above the building standard, the work letter also specifies them, their cost, and method of payment.
A standard tenant improvement work letter is created for improvements throughout the building. This document lays out the minimum improvements that will be constructed in every tenant space.
The lease usually provides a set allowance for tenant improvements. Corus Quay, Toronto, Canada.
ELIZABETH GYDE
LEVEL OF TENANT IMPROVEMENTS. The quality of tenant improvements and the improvement allowances have a definite bearing on the success of marketing the building. Typical items specified in a tenant improvement work letter include the following:
• size and type of ceiling tiles used;
• number of linear feet (meters) of wall and doors for every 100 square feet (10 m2) of rentable space;
• type of wall coverings and color of standard paint;
• quality and type of floor covering;
• number of HVAC registers, mixing units, and thermostats per 100 square feet (10 m2) of rentable space;
• specifications for the telephone system, including the installation of conduit and boxes and the provision of equipment rooms (this item is negotiable, and many businesses have their own systems and installers); and
• type and extent of computer wiring and of alarm and security systems.
Developers should avoid stating the tenant improvement allowance in dollars; instead, they should establish the basic quality and style of improvements for every space. Compatible colors and materials will make individual tenant spaces easier to re-lease when tenants move out.
The following are some common upgrades in tenant spaces:
• kitchen bar consisting of a microwave, small refrigerator, and sink;
• full kitchen and lunchroom with a sink, disposal, microwave, refrigerator, and dishwasher;
• executive bar in office with a refrigerator and sink;
• executive bathroom containing a sink, vanity, toilet, and sometimes a shower;
• climate-controlled computer room;
• fireproof safes or fireproof file rooms; and
• built-in fixtures, such as shelves, cabinets, work-tables, bookshelves, counters, and other cabinetry.
The architect and interior designer may want to carry exterior and lobby finishes into each tenant’s suite or create a series of coordinating colors that will harmonize with the materials used in the lobby and common areas yet allow each tenant to choose a particular color for its own suite.
The spacing of columns and window mullions can lead to many problems in the design of interior spacing. Columns in the middle of a window or in the center of an office can cause challenges during buildout and leasing. When a wall must be built between mullions, one alternative is to end the wall 6 to 12 inches (15–30.5 cm) from the window. The wall is turned parallel to the window until it can be fastened to the mullion in a perpendicular joint. This solution produces oddly shaped spaces, but it does provide a soundproof seal between offices. A flexible scheme for spacing window mullions and columns is essential for meeting the particular needs of each tenant.
Availability of plumbing is also important to the flexibility of the design. Any suite larger than 3,000 square feet (280 m2) should have plumbing available for installation of a sink.
When existing spaces are remodeled, building parts, such as light fixtures, ceiling tiles, metal studs, and air-conditioning components, can be reused, thereby reducing expenses.
Office development requires significant capital. For beginning developers, the financing process is difficult because of their lack of a track record. Typically, beginning developers solicit wealthy individuals as coinvestors; after a sufficiently large portion of the total equity has been accumulated, a local bank is approached for a construction loan. At the same time, the developer would secure long-term permanent financing that would be funded after the building is completed and fully leased.
For developers with some experience, the local equity investment partnerships are overshadowed by commercial mortgage-backed securities (CMBSs), national and global real estate investment trusts (REITs), pension funds, foreign investors, municipal bonds, and property trust companies. The most common form of securitized commercial real estate debt is CMBSs put together by banks, mortgage companies, insurance companies, and investment banks.
The Great Recession continues its negative effect on capital from a debt and equity perspective. In the last ten years, the financial equation used by developers on new office construction was about 65 percent construction loan, 20 percent mezzanine, and 15 percent equity.51 Currently, mezzanine loans are not readily available and developers might receive construction loans of between 50 and 60 percent, leaving them with 40 percent leverage, which requires 20 to 25 percent return to the equity investor, therefore significantly limiting the return for developers.52 Some mezzanine financing might be available as part of a package covering the cost (for example, similar to an equity investor’s structure or straight subordinated loan on the project) if the developer and preleasing are strong.53 The lack of financial conduits and the limited interest among equity investors leave a financing void that banks are not inclined to fill without significant risk-limiting guarantees. Therefore, office development is expected to be mainly need based for a number of years, with lenders and equity partners allowing very little speculation while requiring strong security.
In Ballantyne Corporate Park in Charlotte, North Carolina, the Boyle and Harris Buildings are twin ten-story office buildings that achieved LEED Gold certification.
BISSELL DEVELOPMENT
The Great Recession caused a number of changes in lender practices:
• higher equity requirements—the equity required for the acquisitions is 30 to 45 percent, possibly increasing to a 50 percent L/V ratio due to credit or other risk;
• recourse—the importance of guarantees, depending on the strength of the guarantor and leasing the project can have less than 100 percent recourse;
• stricter loan covenants;
• constraint of future tenant improvements and commission funding; importance of tenant credit even for landlords (landlords focus on a tenant’s operation in their building and evaluate the possibility of dismantling if a tenant has multiple branches); as well as who guarantees the lease;
• significant preleasing (from 40 to 50 percent in 2008 to 75 percent or more depending on the developer, recourse, and equity in the building); and
• developer’s overall profile (banks are now looking at both the proposal for new construction and the financial health of the other projects the developer is involved in).54
Office construction lenders are concerned with leasing, and they typically require from inexperienced developers that 40 to 50 percent of space be preleased in normal markets, 50 to 70 percent in soft markets, and more than 70 percent, along with personal guarantees, in the aftermath of the Great Recession. The due diligence performed for construction loans is detailed, and lenders require concrete proof of rent expectation. The equity requirement can increase from 25 to 50 percent, or greater, depending on such factors as preleasing and a developer’s experience.55 The terms of construction loans range from six months to four years with higher interest rates than permanent loans due to the higher risk. Construction loan rates are based on LIBOR for major lenders, while smaller community banks offer rates based on the prime rate. The final construction rate depends on market conditions and the bank’s assessment of the credit risk posed by the project and developer. Upfront loan fees (points) are common on most construction loans. Most construction loan agreements call for interest to accrue through the construction period. When construction is complete and the building is leased up, the developer obtains a permanent loan or sells the project and pays off the total loan amount, which includes the accrued interest and the principal balance. Major problems that may be encountered by developers include
• the failure to leave enough cushion for cost overruns and slower-than-expected leasing;
• a lack of understanding of the covenants in the loan documents that may allow the lender to increase reserve requirements and adjust the terms accordingly; and
• an exit strategy; will there be buyers for the asset if the developer does not want to hold it after construction?
Some pitfalls can occur between the construction and permanent loans:
• Debt Coverage Ratio (DCR)—Typically, the construction loan has a three- to four-year initial term and a one- to two-year renewal option.
• Valuation—Valuation is very difficult in the aftermath of the Great Recession, with increasing cap rates, limited sale comps, and lenders expecting some equity infusion to renew the loan.
• Recourse—Now, every loan has recourse of 30 to100 percent.56
The permanent mortgage is funded once the building reaches a negotiated level of occupancy—usually, about 70 to 80 percent, a level sufficient to cover debt service on the mortgage. When the loan commitment provides for funding the mortgage before the building is fully leased, usually the developer must post a letter of credit for the difference between the amount that the leases will carry and the full loan amount. Alternatively, the permanent lender may fund the mortgage in stages as the building is leased. Lenders will focus on the effective rather than the market rent, using the lower of the two to underwrite the permanent loan, and they may deduct amounts from the cash flow to cover capital costs and leasing reserves (in case of tenant defaults).
Some office buildings constructed before the Great Recession, during periods of low cap rates, are facing financial challenges with both the loan covenants and the L/V ratio because the exit assumptions are not materializing. For example, even up to 2008, L/V ratios were 65 to 70 percent, with value decreases of at least 25 to 30 percent due to cap rate increases. A shortfall is created for developers and their lenders can request that they cover the difference. If developers cannot infuse equity or a deal is not reached with the lenders, there is expectation of dispositions driven either by banks or by landlords who are trying to reduce the erosion in their equity. A strategy developers can employ to mitigate this problem is to try to coach the appraiser.57
LEASE REQUIREMENTS. Developers must execute leases that satisfy the construction and permanent lenders’ requirements with experienced attorneys while avoiding standard lease forms. Proper building maintenance and tenant services are essential to protect the interests of lenders. Lenders require assignable leases allowing them to take assignment of the rents in the event of default. They prefer clauses that require tenants to pay rent even if the building is destroyed from a natural or other disaster. Sophisticated tenants, however, will not agree to such clauses, even though insurance is available to cover rent when calamities occur. In the event of a calamity, lenders want to receive condemnation and insurance awards first and only then pay the developer. Owners, on the other hand, usually want the insurance money to restore the building.
Lenders tend to dislike rental rates being offset against increases in pass-through expenses. For example, most leases require tenants to pay increases in operating costs over some base figure. They also object to exclusions for increases in management fees and similar items because they reduce the ability of owners to cover these increased costs.
FIGURE 5-7 | Purchase Price Calculation
Bullet loans (standard 30-year self-amortizing mortgages with a ten- to 15-year call) are a common form of permanent financing for office projects. Interest rates are usually lower for short-term mortgages because of the lower interest-rate risk to the lender over time. Occasionally, when inflation and long-term interest rates are expected to fall, interest rates are higher for shorter-term mortgages than for longer-term ones. Other common forms of financing are participating mortgages, convertible mortgages, and sale-leasebacks, all of which are forms of joint ventures with lenders.
Although experienced developers can generally obtain open-ended construction financing without a permanent takeout, beginning developers usually cannot. Standby commitments are one alternative. They represent permanent loan commitments from credit companies and REITs that are sufficient to secure construction financing but are very expensive if they are actually used. Standby loans may run three or more points above prime, thus increasing the default risk during recessions. Ideally, the standby commitment is never funded because it is replaced by a bullet loan or another type of mortgage.
Another alternative to a permanent mortgage is a presale or forward commitment by a purchaser with the developer borrowing against proceeds from the sale for the construction loan. The presale price is determined based on the market capitalization rate. A forward commitment often includes an earnout provision whereby the developer is paid part of the purchase price and the balance is paid as the leasing is completed.
For example, the purchase price of a 100,000-square-foot building with per-square-foot rent of $28 and expenses of $5 can be determined by capitalizing the gross rent from executed leases on 95 percent of the building’s rentable area at 10.467 percent, which equates to approximately an 8.5 percent cap rate on the NOI (figure 5-7, with k representing the overall cap rate):
An earnout would provide for the purchaser’s paying the capitalized value on that portion of the building that is leased at the time of closing and paying the balance later as leases are signed on the remainder of the building. For example, if 50 percent of the building is leased, the purchaser would pay $13,375,000 ($28 × 50,000 square feet ÷ 0.10467) at closing. The balance would be paid as the developer leases the rest of the building. If the remaining 45,000 square feet is leased at $26 per square foot, the developer would receive $11,178,000, for a total of $24,553,000. Therefore, the developer would have failed to “earn out” the full projected amount of $25,412,000.
Lenders normally require 20 to 30 percent of the development cost to be funded by equity sources, although it could be higher depending on the strength of the development team, the difference between the project cost and return, the strength of the market, preleasing, and the overall health of the lending industry. Lender competition to fund new construction during the market peak and before the Great Recession led to significant overleverage, with equity requirements far lower than 20 percent, therefore disincentivizing developers from salvaging their properties.
Joint ventures with lenders and tenants offer one of the easiest methods for covering a developer’s equity requirement. Lenders have preferred participating loans, which give them a share of the cash flows during operations and profits from sale while shielding them from liability and downside risk.
LOAN WORKOUTS. All mortgages include lender-imposed loan covenants. One of the major covenants is a predetermined DCR requirement (currently 1.3 to 1.4). Some banks also require a debt yield ratio (DYR) (NOI divided by the loan amount), which does not account for the interest rate.
The loan covenants will outline the following:
• DCR and DYR testing frequency—usually once or twice a year;
• completion benchmarks and repercussions in case of cost overruns or other noncompliance—for example, if the building is expected to be completed in 12 months the lender provides a cushion of up to four months with monitored checkpoints on the schedule and budget; if the building is not completed after the cushion period, the lender can call for a loan default although all options will first be exhausted to avoid foreclosing on properties under construction as long as the developer is truthful and honest; and
• the time frame in which the loan will be repaid.
A developer facing monetary default must take the following steps:58
• Contact his attorney, who is qualified to review the legal documentation.
• Prepare a solution for the lender. The developer should analyze the causes of the cash flow shortfall and offer short- and longer-term solutions. For an interest-rate problem, refinancing with a lower rate and a comprehensive exit strategy might be the solution. Another possibility can be a request for interest-only payments, reducing payments for a while on a negatively amortized loan.
• Contact the lender and present a solution before receiving the default letter. Developer honesty is critical in resolving any type of problem.
It is important to understand the type of lender the developer is using and what that lender’s guidelines allow. For example, a CMBS lender has less flexible guidelines on additional funding and fewer time extensions than other types of lenders. With a regular lender, such as a bank, the lender should know the bank’s profile. Is it healthy? Is it on the FDIC’s watch list? Is it going to be liquidated? The response can dictate possible outcomes. Assuming the lender is a healthy bank, the next issue for a developer is the types of commitments the bank cannot service.
The strategy for resolving the problem will depend on the type of issue (equity, developer’s financial strength, property status, and so forth) the developer faces. Whether the loan is recourse or nonrecourse is very important. If the loan is nonrecourse, the developer is in a stronger negotiating position, with the only exception being a “bad-boy” guarantee where the loan automatically becomes full recourse if the developer engages in certain actions (not paying taxes, fraud, intentional illegal action, and so forth). In a nonrecourse loan, the developer can return the keys to the lender and negotiate a minimal cost exit (in a minimum equity situation) in lieu of foreclosure. If, however, there are intervening liens (such as mechanic’s liens), a no-cost transfer to the lender will be impossible. But a friendly foreclosure through bankruptcy can save money, as long as the developer agrees and has not committed fraud.
The Campus at Playa Vista in Los Angeles was planned as an indoor/outdoor work environment. The development is part of a large reuse of an industrial brownfield.
Another option might be for the developer to buy back the loan from the bank, for example, if the property is now worth less than the original loan. If the developer wants to salvage the property, avoiding default status is essential because the loan becomes classified and the bank has to report it differently to its examiners. Even if the developer makes regular payments later, the bank might need to treat the loan differently due to its default status.
In any default situation, whether a construction or permanent loan is out of balance, the lender will take the following steps:
• Default notice—The notice is sent to the borrower, outlining the problem and inviting the developer to discuss possible options while reserving the right to foreclose.
• Lender’s architect’s inspection—The lender’s architect will visit the site to reevaluate the budget and assess the issue. Sometimes, the problem can be resolved easily, such as addressing an unpaid impact fee the developer was unaware of or a subcontractor that went out of business. The developer should have a contingency built into the budget to deal with these types of issues.
• Title—The lender will search for any liens against the property because they are paid ahead of the mortgage in certain states. They will also make sure that the money expended until this point has been allocated to the proper contractors and the scheduled work has been completed.
• New underwriting—The lender starts from zero, by examining the loan budget and the current equity and identifying any gap between them. If a gap exists, either the lender or the borrower will need to cover it.
• Negotiations with developer—The lender meets with the developer, who is expected to have a plan to facilitate a nonforeclosure resolution.
• Resolution without foreclosure—If a nondefault agreement has been reached between the lender and the developer, the shortfall will be covered by one of the following options: (1) the developer fully funds the shortfall; (2) the lender funds the shortfall because of the developer’s lack of funds; or (3) the developer and the lender fund the shortfall. If the borrower is honest and cooperative, the bank will consider extending the terminal loan and modifying it.
• Foreclosure resolution—The lender forecloses and a receiver is appointed for the day-to-day operations. Five key factors can lead to foreclosure: (1) the property is worth less at the time of completion compared with the initial lender investment and the developer cannot provide cash infusion; (2) developer dishonesty; (3) developer-tenant deals, with developers requesting funding for space built out without truthfully disclosing their involvement in the deal; (4) lack of developer interest in salvaging the property (key to the developer’s effort to salvage the project is the amount of equity); and (5) the developer does not have any funds and cannot raise any funds to hold the property.59
Marketing an office building begins in the initial planning phases and continues through the stages of attracting prospective tenants or buyers and successfully completing negotiations with them. The crux of a marketing plan is to identify the target market segment (discussed earlier under “Market Analysis”) and to convince that segment of the building’s desirability.
The key to successful marketing is to focus on the criteria that are important to the target market and to emphasize the provision of these features to prospective tenants. Important features include
• exceptional location and access;
• competitive rental rates;
• efficient floor configuration;
• amenities and services (conference and fitness centers, restaurants);
• distinctive design;
• landlord stability;
• a high standard of tenant improvements; and
• Energy Star label or LEED certification, natural lighting, and air temperature control, which are among the pivotal features in an office building for tenants.60
Guided by the market analysis and controlled by a strategic marketing plan and budget, the developer should undertake a variety of initiatives to attract and satisfy the needs of prospective tenants with a systematic approach.
The marketing strategy lays out a basic plan for publicizing the project and defines the roles of members of the marketing team. It should include a description of the project and its target market and a realistic analysis of the project’s relative position in the marketplace. It must also include a statement of the developer’s financial goals and investment strategy, including exit strategies. A leasing plan with guidelines for rental rates and potential concessions is also essential.
Developers usually start marketing space when the building is still in the design phase to reduce their risk, although tenants are reluctant to lease preconstruction space. The larger the building and the longer the construction schedule, the more difficult preleasing becomes.
A good location often attracts a build-to-suit tenant. The developer must be willing to adapt the building to the tenant’s distinctive requirements, which may later pose problems if the building must be leased to another tenant. Nonetheless, the advantages of build-to-suit projects—especially the advantage of a committed tenant—outweigh their disadvantages.
ADVERTISING. Advertising is a key element of the marketing strategy that promotes the project’s image while trying to attract perspective tenants. The advertising must be well conceived and designed to convey the appropriate image of the project. Advertising should be unified by a theme and a style. A name, logo, and identity design—to be used in all materials, including ads, websites, and printed matter—can be developed early during the project’s conceptual planning phases to ensure continuity in image from design to marketing.
Property advertising has changed by virtue of technology and client needs in recent years. Beyond listing the property information on brokerage websites, a property website can be set up and maintained easily. Features should include a project overview, building data, typical floor plans, a summary of technical specifications, and a location map. Photos illustrating construction progress and leasing updates can also help sell the project to prospective tenants before its completion. E-mails and progress newsletters are other effective advertising techniques for brokers.
On-site signboards should announce the amount of available space, a contact person, and a telephone number. Signs should be perpendicular to the road, and the letters should be large enough to be read easily by passengers inside a vehicle driving by the site.
PUBLIC RELATIONS. Public relations firms assist the developer with news releases, promotional ads, and special ceremonies covered by the press. Newsworthy items include groundbreaking, land closing, signing of leases with major tenants, securing of public approvals, construction progress, building completion, first move-ins, and human interest stories on individual tenants. Public relations events should be limited because they can be costly and not particularly effective in reaching the target market.
MERCHANDISING. The developer must ensure that the site is free from construction trash, the completed building has a high-quality image, and the lobby creates an inviting atmosphere.
Ideally, the leasing office should overlook the construction site. At the very least, the leasing office should include an executive office, a staff office, an open area for support staff, and a conference room. In terms of decoration, the office should contain the standard tenant improvements to show prospects how attractive their space will be without added expense for extras or upgrades.
Models, pictures, and other graphic aids should be displayed to generate interest and to facilitate movement throughout the sales office. Scale models are useful in obtaining financing and gaining public approvals, as well as in helping prospective tenants visualize the space. Floor plans and computerized presentations incorporating virtual reality tours of the offices can also be quite helpful.
Brokers are used in nearly all office-leasing transactions. Existing tenants, however, are increasingly approaching their landlords directly for renewals and extensions to benefit from the lack of the brokerage commission. Leasing can be done by an in-house team or outside brokers. An in-house team allows the developer greater control, but the cost may be prohibitive for a small or beginner developer. Arrangements with real estate brokerage firms can provide market experience and access to a professional sales force, but it does mean that the developer has less control over marketing and leasing.
WORKING WITH OUTSIDE BROKERS. A brokerage firm can bring an in-depth knowledge of major competitors and tenants looking for space. Brokers also spread the word about a new development through their network of development agencies, chambers of commerce, business organizations, and so forth. In hiring outside brokers, developers should consider certain points:
• the size and competence of the broker’s leasing staff; and
• the number of competitive buildings the broker is working on (brokers with many clients may not be able to devote sufficient time or interest to a new developer’s project; a younger or smaller agency with fewer clients may offer better service but may have fewer contacts).
Brokers may have a contract with the developer that ensures them the exclusive right to negotiate all deals. Alternatively, the developer may opt for an open listing, which allows any broker to act as the primary broker on a deal. Developers should keep brokers informed about their project through presentations and monthly news releases. Traditionally, a broker brings a prospective tenant to the developer and assists in negotiating the terms of the lease. In some situations, developers may prefer to negotiate the lease themselves or with the use of legal counsel.
Commission rates for brokers are typically a percentage of rental income determined by market conditions. As a rough guide, a beginning developer could expect a broker to request a 6 percent commission rate in the first year of the lease with a declining percentage for the later years. The typical payment schedule for brokers’ commissions is half upon lease signing and half upon occupancy or at the time rental payments begin. In cases in which a substantial period of free rent is offered at the beginning of a lease, it is common for a developer to pay one-third of the commission at the signing of the lease, one-third at occupancy, and one-third at the commencement of rent.
FIGURE 5-8 | Typical Breakdown of Gross Rent for Office Space
USING IN-HOUSE BROKERS. Some developers prefer to employ an in-house staff of leasing agents. Although salaries are costly, an in-house staff can substantially reduce the cost of leasing space because of their lower commissions (typically, 3 to 4 percent of the full value of the lease).
An effective in-house brokerage department offers its employees many of the same training programs used in outside brokerage firms. For example, some companies have weekly education sessions for salespeople covering self-motivation, product presentation, and negotiation techniques. Whether to use in-house brokers or outside brokers depends largely on market conditions and the size and expertise of a developer’s staff.
TYPES OF LEASES. Three types of leases are used in office projects: gross leases, net leases, and expense stop leases. Each has its advantages and disadvantages.
Gross Leases. The landlord pays all operating expenses, absorbing the risk of rising expenses. A typical rent breakdown is shown in figure 5-8.
Net Leases. Three variations of net leases are common, although definitions can vary by market. Under a net lease, the tenant typically pays a base rent plus its share of certain building operating expenses, such as utilities. Under a net-net lease, the tenant pays everything under a net lease plus ordinary repairs and maintenance. Under a triple-net (commonly referred to as NNN) lease, the tenant pays all the building’s ongoing operating expenses, including capital improvements. Ultimately, the lease itself, which is a product of negotiation between owner and tenants, defines which expenses fall under the responsibility of the tenant and the owner.
Expense Stop Leases. Expense stop leases involve sharing expenses between the tenant and the landlord. The landlord pays a stated dollar amount for expenses, and the tenant pays any expenses above that amount. Normally, the expense “stop” is determined by an estimate of expenses for the first operating year. Thus, the tenant pays any increases in expenses above the stop over the term of the lease after the second year of the lease term. An expense stop shifts the responsibility for increased expenses to the tenant in much the same way a net lease does. A lease may also be structured so that the tenant is responsible for the increase in utility costs but not other expenses.
The lease document sets forth the terms and conditions under which the tenant’s rights to use the space are granted. Both developers and corporate tenants have their own leasing forms, and the initial negotiations determine which form will be used as the starting point. Lease negotiations focus on four major issues: rent, term, tenant improvements, and concessions, such as free rent or moving expenses. Anchor tenants (those occupying a significant portion of the building) have lease terms running ten or more years, with rent escalations every year. The rest of the tenants usually have three- to five-year leases; the shorter term allows the landlord to renegotiate the terms of the lease to match inflation and gives tenants greater flexibility.
The base rent depends on market conditions. If local vacancy rates exceed 15 percent, tenants enjoy a strong bargaining position, and the base rent could be lowered accordingly. Provisions such as dollar stop or full stop clauses are created to allow for rent adjustments for long-term leases. An estimated dollar amount (the dollar stop) for real estate taxes and another amount for other operating expenses and insurance are determined at the beginning of the lease. Under consumer price index clauses, rent is adjusted annually based on the CPI or the wholesale price index, which is tied to the cost of living in the United States. During inflationary periods, developers tend to prefer CPI leases. In softer markets, CPI leases are harder to negotiate. In periods of low inflation, fixed increases may be more common. Tenants are often willing to accept 3 percent annual increases, which in recent years provided larger rent increases than a straight CPI adjustment.
The key to successful lease negotiations is being able to respond to the tenant’s needs while negotiating for everything. Does a tenant require free rent for certain periods, low initial rent with later escalations, or above-standard tenant improvements? Generally, smaller tenants prefer higher tenant improvement allowances because they often lack the liquidity for improvements in advance; larger tenants often prefer free rent for certain periods.
Every lease should specify the following information:
• location of the space in the building;
• size and method of measuring the space;
• options for expansion, if any;
• duration of lease term, renewal options, and termination privileges;
• rent per square foot (per m2);
• services included in the lease and costs associated with those services;
• interior work to be performed by the developer under the base rent;
• operating hours of the building;
• the landlord’s obligations for maintenance and services;
• the tenant’s obligations for maintenance and services;
• escalation provisions during the lease term;
• number of parking spaces, their location, and terms of their use (for example, whether designated or undesignated);
• allowable use of the leased space permitted by local zoning ordinances and building rules;
• date of possession and date that rental payments are due; and
• sublease and assignment privileges, if any.
Office building management requires regular maintenance, efficient operation, and enhancement of the property’s value. Larger buildings have property managers on site, while smaller buildings may share a property manager. The agreement between the developer and the property manager should identify the duties and responsibilities of each party, including the authority to sign leases and other documents, incur expenses, advertise, and arrange bank/trust agreements. Also included are provisions on record keeping, insurance, indemnification, and management fees. Most management fees are quoted as a percentage (ranging from 1 to 6 percent) of effective gross income. Smaller developers might manage their buildings for the fees they generate and to maintain close ties with tenants.
The functions of a property manager include maintaining the building, developing and maintaining good tenant relations, collecting rent, establishing an operating plan, creating a budget, maintaining accounting and operating records, hiring contractors or vendors servicing the building, paying bills, overseeing leasing, developing and managing maintenance schedules, supervising building personnel, providing security, addressing issues related to risk management, coordinating insurance requirements, and generally preserving and attempting to increase the building’s value.
Perseo, on the outskirts of Milan, Italy, is a 177,000-square-foot (16,000 m2) sustainable development of two office buildings connected by a slender four-story bridge.
ENRICO CANO
The management team can significantly affect a property’s value either positively or negatively. The projections of income and expenditures that are updated monthly are among a property manager’s top priorities. The income side includes rents as though the project were fully occupied, along with any other income from the property. The gross income is adjusted for anticipated losses (for example, vacancies and turnovers). The three major operating expenses are taxes, utilities, and cleaning, with the management staff having better control over the latter two. A number of strategies can be applied to reduce operating expenses, such as renegotiating service contracts, making staffing changes (on-site personnel can be decreased if the facility has smart systems that allow remote supervision), reducing energy usage, setting back temperature controls, and minimizing downtime and landscaping. Operating expenses of portfolio properties can decrease if electricity is bought in bulk and the same cleaning staff is used for the entire portfolio.61
Key issues toward ensuring tenant satisfaction are the coordination of tenant improvements and property maintenance. Many developers have an in-house project manager for construction oversight while maintenance is routine—preventative and corrective on the building’s mechanical and structural systems. If the lease gives the tenant responsibility for maintenance or landscaping, the developer should retain the right to order the work if the tenant fails to do so and charge the tenant for the cost.
One of the most important management tools is the lease agreement. Developers should ensure that leases contain clauses stipulating that
• tenants must not alter the building without the landlord’s consent;
• tenants must not do anything that might increase the costs of fire insurance or create noise or nuisance;
• tenants must not use the building for immoral or illegal purposes; and
• if tenants remove floor, wall, or ceiling coverings, they must restore the surfaces to the condition that existed when they first took possession of the space.
The management team needs to provide high-level service to the tenants and build a relationship through scheduled meetings and independent surveys. The team members should also make sure they satisfy the tenant decision makers, not only the employees.62 Some companies also have tenant portals that include announcements, forms, life/safety training videos, and so forth.
The recent recession has led to zombie buildings, which are currently worth significantly less than what their owners owe and where refinancing is not a viable option. The developer/owner might have bought a building at the height of the market; although the loan might be serviced, the market value decreased and neither the owner nor the lender is willing to provide funds for buildouts or broker commissions when space becomes vacant. This situation is less of a problem for bigger tenants because they can afford the built-out costs and take free or reduced rent incentives. But attracting medium-sized or smaller tenants that need a built-out space allowance up front while being unable to use existing space is difficult.
Landlords across the United States see energy efficiency, water volume control, and use of sustainable products as core sustainability factors. The main challenge is faced by older office buildings, which will eventually need to pursue Energy Star and/or LEED certification to remain competitive in the market. Many landlords of Class A and Class B buildings have tried to evaluate their buildings for LEED certification, but the retrofitting costs can be prohibitive even in a good market. The first steps in pursuing Energy Star or LEED designation are63
1. auditing the performance of the building’s system over a 12–18 month period, including energy temperatures, water volumes, and so on; and
2. assessing the equipment changes needed to improve energy and water performance. Some landlords (especially of Class B and B- buildings) stop at this step due to the significant cost associated with the retrofit of outdated mechanical systems, regardless of the available energy incentives.
If the building receives a LEED-EBOM certification, staff will require training on new policies, while vendors and partners should abide by the new protocols established, which will be continuously monitored by management staff. Properties pursuing LEED certification see an initial hike in their operating budget for repairs and maintenance, due to the installation of filters for air quality, timers, sensors, and other equipment, while significant operating savings might take three to four years.64
The decision to sell depends on the needs of the equity partners, the term of the construction or permanent loan, market conditions, and the developer’s analysis of alternative investment opportunities.
Office buildings are commonly sold at (1) stabilized occupancy, (2) after the first full year of occupancy (when the first CPI or fixed adjustments occur), or (3) after the leases are renewed. Usually, the highest internal rate of return is achieved if the building is sold as soon as it reaches stabilized occupancy. In competitive markets, however, most developers prefer to wait until just after the leases first roll over or until the first rent escalations have occurred. At this point, the highest net present value (at a discount rate of 12 to 15 percent) is often reached. On the other hand, long-term investors usually plan to hold buildings for at least seven years.
Developers can take several actions to position a building for sale:
• hire a building inspection team to thoroughly inspect a building’s mechanical and other systems and to prepare a report that can be shown to prospective buyers;
• prepare summaries of a project’s income and expenses and ensure that accounting records are in order;
• make sure that a building is clean and has a well-landscaped and well-maintained appearance or curb appeal;
• prepare a summary of all outstanding leases on a building; and
• create a marketing brochure that describes a project’s noteworthy qualities—its tenants, management, location, and position in the market.
Office development is challenging but straightforward for a beginning developer. Avi Lothan notes that the marketplace for new office construction is becoming increasingly tenant specific and opportunistic based on the signing of a major lease.65 Tenants of significant size or those consolidating multiple area operations require contiguous space, which is not always readily available in the market, triggering new construction of either buildings with big floor plates or small build-to-suit buildings. Even when space is designed carefully for specific tenants, the space needs to remain flexible and accommodate changes.
Development of flexible and sustainable space is almost a must for new development, while the addition of smart building systems is more frequently seen among existing downtown office buildings. Given the progression of technology and the resulting innovative approaches to energy management, the adoption of smart grid systems in some form seems inevitable among all new office construction in the future, according to Mike Munson of Metropolitan Energy.66
The Great Recession has led to a higher propensity of short-term leases (three to five years instead of a ten-year commitment) and a higher ratio of renewals compared with new tenant deals, says Vicky Noonan. Tenants with leases expiring in one to two years tend to extend them for four years, effectively reducing their rent (the cost to move can be as high as $30 per square foot [$323/m2], according to Eric Sorensen). The Great Recession and the decrease in property values have led even Class A properties in some areas to deny tenant improvements and broker commissions, even for existing tenants that renew their leases.67
Rents are highly dependent on location and the amenity package, with sustainability becoming an increasingly important factor. Although offices can be built almost anywhere, firms want to be located where their employees want to work. Tenants are willing to pay a premium for the right location, which attracts and retains key employees. In prime locations, office space can generate higher land values than any other use.
Central business districts no longer have the preeminence they once had (with the exception of 24/7 cities), and office buildings are widely dispersed throughout metropolitan regions, although suburban rents and property values are usually significantly less than those in the downtown area. A large concentration of office space defines today’s edge cities that lie at major highway intersections at the periphery of every major American city, although transit-oriented development is becoming increasingly attractive among major developers compared with edgeless cities.
Office development is relatively compact and uses less land per employee than industrial or retail development. But office buildings do generate high peak traffic volumes. Office buildings constitute a primary use in redevelopment areas and local officials often embrace this use as an economic development tool.
Office buildings typically take at least two years to build and lease up, and market conditions might change dramatically during this time. During the Great Recession, a number of office developers were caught at various stages of development with their projects requiring lender workouts to mitigate the financial shortfalls in the short and longer run. With a lot of the capital instruments used by developers on the sidelines and a weak job growth, speculative development is not expected to commence for a number of years, while need-based development is expected to gradually increase.
This chapter concludes with two case studies of LEED-certified office buildings, reflecting the increasing pervasiveness of sustainable development. The first, 17th and Larimer, is a redevelopment in downtown Denver. The second is 11000 Equity Drive, a new corporate headquarters in suburban Houston.
Located in downtown Denver, 17th and Larimer is a multitenant, LEED New Construction, adaptive-use office property owned by Seventeenth & Larimer LLC. The company representing the owners was formed by Kenneth Gillis, president of Centennial Realty Advisors; Randy Nichols of Nichols Partnership; and other equity partners. Nichols Partnership conducted the property renovation during 2008 and 2009. According to Gillis, the main motivation for the property acquisition was “the excellent location, which, combined with the building improvements, would raise rents, lower the cap rate, and thus increase the property value.”
LOCATION
The building occupies a 0.45-acre (0.18 ha) site formerly known as the “Larimer Corporate Plaza.” The current owners changed the property name to “17th and Larimer,” as part of a rebranding. The property is adjacent to the Lower Downtown historic district, which is popular for its many restaurants, bars, clubs, and amenities. Larimer Square retail district is two blocks away at 15th and Larimer and the 16th Street pedestrian mall is one block away. The property is one block from the Regional Transportation District’s lower downtown hub and adjacent to the 16th Street Mall bus connections. Rail and road transportation networks are also close, with Union Railway Station located three blocks away, light rail five blocks away, and the North Valley Highway (I-25) nine blocks away. Also within walking distance are the Denver Performing Arts Complex, the University of Colorado-Denver, the Colorado Convention Center, and Coors Field baseball stadium.
PROPERTY DESCRIPTION
Originally named the Barclay Building, the property was constructed in 1979 and opened in 1982, later becoming Larimer Corporate Plaza. The current rentable building area is 118,263 square feet (10,986 m2), with 93 percent allocated to office use and the remainder occupied by five ground-level retail tenants. Underground and structured parking provide 55 parking spaces. The roof of the side parking structure is landscaped as an outdoor patio. Since 1996, the building sold three times. The most recent transaction occurred in 2007 when the property sold to Seventeenth & Larimer, LLC, for $16,825,000. Kenneth Gillis, president of Centennial Realty Advisors, LLC, selected the property and performed the financial analysis, which indicated that an extensive renovation of the asset and the improvement of the classification from B to A with a LEED certification would be a profitable venture. Vacancy was at 8.3 percent; it increased to 15 percent as a result of the owners’ schedule of remodeling of both the interior and exterior. Although vacancy increased because of the renovations and economic recession, the property’s repositioning lets it compete directly with the few LEED-certified Class A office properties in the area.
The interior includes a grid of columns with 20-foot (6 m) spacing, which reduces column interruption for small tenants. The building core includes an emergency stairwell and three elevators, one used for freight. The building has a classic corner office design with a sawtooth setback on both Larimer and 17th Streets, permitting multiple corner offices.
Glass and granite cladding are used for the building’s exterior at the retail level, and concrete panels with stucco-clad cornices cover the upper levels. The first substantial renovation took place in 1996 and included recoloring of the concrete panels, elevator redecoration, a new signage system, and granite cladding for the retail level. This renovation improved the building’s classification from C to B and attracted new tenants.
The second substantial building renovation, the focus of this case study, commenced after the latest property acquisition in 2007. The owners determined that the building was underused based on its location and the strength of the office lease market. A significant makeover was necessary to upgrade the building from a Class B to a Class A property. The extensive renovation was completed in May 2009 and included the redesign of the facade, relocation of the main lobby to the corner of 17th and Larimer Streets, a complete remodel of all the building’s common areas, and extensive upgrades to the structure’s mechanical systems.
ADAPTIVE USE AND LEED
The remodeling goal was twofold: (1) to create a new identity for the property and (2) to adopt a green approach for a large-scale project with short- and long-term benefits for the owners, tenants, and those looking to lease space in LEED-certified buildings. The LEED-NC 2.2 designation was pursued based on the U.S. Green Building Council’s recommendation, and construction was completed within nine months. The renovation included the replacement and reconstruction of the ground-level facade with new porcelain tile and a curtain wall window system on the corner of 17th and Larimer. The second-floor parking garage was faced with new aluminum grating panels. Metal wall panels were installed over the existing precast exterior on floors three through eight.
All windows in the building were replaced with new low-E glazing. Common areas were completely remodeled, including all new bathrooms with low-water-use plumbing fixtures; energy-efficient light fixtures; new floor, wall, and ceiling finishes; and remodeled elevator cabs. The ground-floor lobby was relocated to allow for a main entrance at the corner of 17th and Larimer. The new lobby features a 30-foot-long (9 m) backlit glass “glow wall.”
A new 2,400-square-foot (223 m2) retail space was created adjacent to the new lobby and entrance. Exterior patio space on the building’s third level was enclosed and recaptured as additional leasable interior space for the building. The cost of recapturing this space was a fraction of the cost of other office space in the building, so it was beneficial to the overall project pro forma returns.
The upgrades that enabled the project to qualify for LEED certification included the following:
• WATER EFFICIENCY—All landscaping is water efficient. Potable water consumption for landscaping is reduced by 50 percent over a calculated midsummer baseline. All plumbing fixtures were replaced with low-water-use fixtures.
• ENERGY AND ATMOSPHERE—The energy performance of the mechanical systems and building envelope was optimized. Energy-efficient lighting was used throughout all building common areas. New energy-efficient windows and an energy-efficient chiller replaced old ones.
• MATERIALS AND RESOURCES—The renovation used 95 percent of the existing walls, floors, and roof, and 50 percent of the interior nonstructural elements. Forest Stewardship Council-certified wood was used where replacement was required.
• INDOOR ENVIRONMENTAL QUALITY—A construction indoor air quality (IAQ) plan was developed and implemented, as was an IAQ management plan for the construction and preoccupancy phases of the building. Low-emitting materials were selected for all adhesives, sealants, primers, paints, carpets, woods, and agrifiber products.
• BUILDING THERMAL COMFORT SYSTEMS were designed to meet the standards of ASHRAE 55-2004.
• INNOVATION AND DESIGN—The developers implemented and mandated a building-wide recycling program, as well as a sustainable operations and maintenance policy.
MARKETING AND TENANTS
Currently, 22 tenants occupy almost 74 percent of the building. A challenge during the extensive renovation was the owner’s goal of high occupancy during construction. The strategies applied to accomplish this mandate required that the majority of disruptive work be completed during off-hours and that tenants be continuously updated on the construction progress. Careful scheduling and timing of potentially disruptive activities were crucial.
FINANCING
The property was acquired by Seventeenth & Larimer, LLC, in 2007 for $16.8 million. Capmark Bank provided the redevelopment loan at an initial amount of $14.2 million and the ability to increase it by $5.5 million for the redevelopment, tenant improvements, and commissions. The total loan was $19,700,294 with a floating interest rate that averages at about 6.5 percent. Seventeenth & Larimer, LLC, acquired the property with an equity amount of $3 million. The only lender requirement was to recapture the 6,877 square feet (638 m2) of leasable space on the building’s third floor as part of the renovations. The final cost of the renovation was almost $11 million.
EXPERIENCE GAINED
The renovations cost the developer about $70 per square foot ($753/m2). They increased the property value for both the owner and the tenants. The key elements from the owner’s perspective were the upgrading from Class B to Class A. The LEED certification was also critical to enable the building to capture that increasing niche of tenants seeking a green building. The small supply of such buildings in downtown Denver gives the property a competitive advantage over all non-LEED properties. The recapturing of almost 7,000 rentable square feet (650 m2) by enclosing an exterior patio on the third floor added valuable leasable space. The direct benefit for the owner was the rent increase because of the property’s reclassification, which allows it to compete with Class A rather than B properties. Because of the improvements, the majority of the existing tenants remained throughout renovation and rent escalation.
The tenants’ perspective on the added value from the renovations was captured through a survey titled “Thermal Comfort Study” and informal comments made by the tenants to the property manager. The vast majority of tenants were pleased with the heat load in their workplace. Before the renovations, the building’s HVAC system was unable to handle the heat load especially on the south side of the building. After the renovations, the tenants throughout the building indicated that they were far more comfortable. In addition to the survey, a number of tenants approached the property manager indicating that all the interior improvements made their workspace more productive.
During construction, the project manager, Dan Schuetz of Nichols Partnership, was faced with some unexpected problems, which were time-consuming and costly to resolve:
• Construction vibration problems in the cast-in-place concrete structure echoed throughout the building and could not be isolated, requiring all hammer drilling to be performed during tenant off-hours, which increased projected costs.
• The existing exterior curtain wall glass was failing. Even if exterior renovations were not scheduled to take place immediately, the glass curtain wall would need to be resecured to the structure within the next ten years.
• The city of Denver required the new exterior wall fire rating to be brought up to code.
• To qualify for LEED credits, the existing HVAC mechanical systems needed substantial retrofitting to draw an adequate amount of external fresh air. This retrofitting was technically challenging and costly.
• The LEED “Construction Waste Management” credit can be earned by recycling a certain percentage of materials removed from the building. The team planned to divert 50 percent of the construction waste from the disposal of glass but was unable to find a company that would recycle all the removed glass even though it was being given away free.
Three key lessons were learned from the renovation process:
1. IMPACT ON THE TENANTS—The process affected the tenants, although every possible effort was made to minimize disruptions. Keeping an open dialogue between tenants, property management, and construction team was the key to the success of this project.
2. FLOOR ADDITION—The construction team spent time, money, and effort in exploring the possibility of adding one more floor, but it was not pursued because of cost and time constraints.
3. CONTINGENCY BUDGET—In this project, the contingency was 8 percent, which was totally spent on exterior wall fireproofing improvements, HVAC upgrade, exterior glazing, and so on. In hindsight, the contingency of a property renovation should have been a minimum at 8 percent and at best 10 percent of the hard cost, allowing the construction team to deal with substantial unforeseen challenges.
FINANCIAL PROJECTIONS
The project feasibility was evaluated through a pro forma examining postconstruction expected cash flows and expected postconstruction cap rates to arrive at reversion value (see figure B).
FIGURE A | Project Data
FIGURE B | Project Cost Summary and Pro Forma
This case study focuses on a multitenant, LEED Gold building in Houston, Texas, that is the corporate headquarters of Satterfield & Pontikes. The goal was to develop a cutting-edge property to house the company’s headquarters and to showcase the innovative mind-set of the owner. The innovative technologies applied in the property design and development and the team structure were recognized with multiple awards from the national, state, and local chapters of the American Institute of Architects and the Associated General Contractors of America.
LOCATION
The building is located at 11000 Equity Drive in the Northwest Far Submarket on a four-acre (1.62 ha) site. It is part of the Westway Park development in Techway, which is adjacent to Beltway 8. The vision of the initial developer, Wolff Companies, included the adoption of green strategies in its business park design, which would eventually become a green oasis in Houston. Westway Park is an area of 150 extensively landscaped acres (61 ha) with thousands of trees. Among them are more than 83 native Texas hardwood trees protected by a permanent conservation easement.
George A. Pontikes, Jr., the CEO of Satterfield & Pontikes, took this vision further with the use of technology and developed a building that became the eighth LEED-certified or -registered building in the park.
SITE SELECTION AND ACQUISITION
Pontikes’s goal was to develop a green building in an energy corridor. The site is located in an energy corridor and is also in proximity to a major highway interchange (Beltway 8 and I-10). The innovations applied in the construction process expedited the building’s occupancy (only ten months from the land acquisition) and generated development cost savings of 20 percent.
APPROVALS, CONSTRUCTION
The property was developed in a business park that was already zoned for office use, and it only required the typical building permits. No restrictions were imposed by the business park, and no additional approvals were required for the development of the green building.
Pontikes’s goal was the cost-efficient and expedited design-build of his new and innovative corporate headquarters. All members of the project team used 3-D modeling to improve efficiency by facilitating faster review of multiple design options and effective conflict resolution throughout the construction phase. Satterfield & Pontikes reported a 20 percent cost savings compared with traditional design methods as a result of the sharing of 3-D modeling among all project participants.
Another innovation in the preconstruction and construction phases was the adoption of building information modeling (BIM) by all the project team participants. BIM is usually applied in large-scale projects, but using it in the development of this small-scale building led to a cost saving of 10 to 15 percent and eliminated all change orders at the job site. The use of BIM facilitated the fast information dissemination of different design scenarios and material costs among the project participants. It increased the project efficiency, allowing for task completion in days instead of weeks, eventually leading to completion in only ten months. A side benefit was the reduction of paper waste because of the electronic information sharing.
JUD HAGGARD
JUD HAGGARD
The project comprises two three-story office buildings, constructed in 2006 with a rentable building area of 65,000 square feet (6,038 m2) and an FAR of 0.37. In 2008, it was acquired by Seligman & Associates for $14,675,000. The two rectangular buildings are slightly shifted and perpendicular to each other, with the second box hosting the main entrance and protecting the interior from the eastern and southern sun. The intention for the structure’s interior was to accomplish a high-quality, occupant-friendly environment. This goal was accomplished with ample corridors with transparent walls, allowing for significant exterior light penetration into the building’s interior. Flexible circulation space allows for tenant expansion or contraction capabilities. Corner space serves as conference areas and lunchrooms.
Each building has one elevator and one emergency stairwell. The structure’s exterior is enhanced with a sunshade system that increases thermal efficiency while providing glare-free views for all the occupants. The structure is made of cast-in-place concrete with the first box being wrapped in curtain wall bays and an exterior facade mullion cap that allows interesting light reflections. The facade of the second box is capped with a thin cornice overhang that completes the trabeated design while providing sun protection.
FIGURE A | Project Data
FIGURE B | LEED Certification Points
FIGURE C | Project Cost Summary
Both boxes reduce the heat-island effect with membrane roofs. The buildings and parking lot are well landscaped. The site’s perimeter includes 82 trees, which are a noise and aesthetic buffer from the roads. A central park leads to the building entrance and has benches, a walkway, and a variety of trees, creating a relaxing oasis just steps from the offices.
LEED CERTIFICATION
The property was awarded LEED Gold Core and Shell Certification in 2007, making it the first LEED Gold building in Houston. The point breakdown is contained in figure B.
During construction, more than 75 percent of the construction waste was recycled. About 96 percent of the interior space has exterior views and the combination of efficient light fixtures, window-shading devices, and fritted glazing decreases the overall energy usage by more than 12 percent. Water-efficient fixtures decrease interior water use by 30 percent. The structure’s heat-island effect was minimized with cool roofing materials and landscaping. The use of a highly efficient irrigation system combined with the selection of native grasses and plants (which are more resilient and require less watering) resulted in a 50 percent reduction in exterior water use. The developer’s embrace of green strategies continued after construction with the continuing purchase of more than 70 percent of its energy needs coming from a sustainable source.
FIGURE D | Operating Pro Forma
MARKETING AND TENANTS
The property was completed in just over ten months after purchasing the land. Currently, it is fully leased, with 50 percent of the space occupied by Satterfield & Pontikes, 41 percent by another anchor tenant, and the rest by two small tenants. All leases are long term with expiration dates in 2012 and 2015. The property credits its desirability to a combination of location, high-quality design, and environmentally friendly construction and landscaping, all making the building an appealing place to work and to conserve energy. The cost savings generated by the property’s green approach attracted tenants that pay rents exceeding the original pro forma expectations.
FINANCING
The property was financed by Amegy Bank of Texas. The total development cost was $12.2 million, including tenant finishes (see figure C). The land cost was $1.2 million. The equity for the project construction was $1,059,000. The financial feasibility was determined with a simple pro forma/capital budgeting model (see figure D).
EXPERIENCE GAINED
George Pontikes’s vision for an innovative green property with an expedited construction schedule and a small budget was realized and the property reached full occupancy within a year after completion. Kirksey Architects found that the application of the BIM process was pivotal in the project’s success because it expedited communication, reduced the construction schedule, streamlined documentation, identified potential conflicts and mistakes early, allowed the efficient evaluation of different materials and their effect on energy efficiency and overall appearance, and allowed for an accurate cost analysis.
Note: Satterfield & Pontikes staff members Jess Arnold and Debbie Moore and former staff member Natasha Dasher assisted in developing this case study.
NOTES
1. Interview with Bill Rolander, principal at the John Buck Company, Chicago, Illinois, summer 2009.
2. Interview with Cathy Stephenson, senior vice president, national director of operations, Grubb & Ellis, Chicago, Illinois, summer 2009.
3. Interviews with Greg Van Schaak, Hines, Chicago, Illinois; Rafael Carreira, Eric Sorensen, and Bill Rolander, the John Buck Company, Chicago, Illinois, 2009; and Dennis Harder, Joseph Freed & Associates, Chicago, Illinois, 2009.
4. Interviews with Bill Rolander and Greg Van Schaak, 2009; and Milda Roszkiewicz, senior vice president, Wells Fargo, Chicago, Illinois, 2010.
5. Anthony Downs, Real Estate and the Financial Crisis: How Turmoil in the Capital Markets is Restructuring Real Estate Finance (Washington, D.C.: ULI–the Urban Land Institute, 2009.
6. Interviews with Milda Roszkiewicz, 2010; and Anthony Frink, partner, Holland & Knight, Chicago, Illinois, 2010.
7. U.S. Environmental Protection Agency, Energy Star website, www.energystar.gov.
8. U.S. Green Building Council website, www.usgbc.org.
9. Interviews with Greg Van Schaak, Rafael Carreira, Eric Sorensen, Bill Rolander, and Dennis Harder, 2009.
10. Interviews with Bill Rolander, Rafael Carreira, and Greg Van Schaak, 2009.
11. Piet Eichholtz, Nils Kok, and John M. Quigley, “Doing Well by Doing Good? Green Office Buildings,” American Economic Review 100, no. 5 (2010): 2492–2509.
12. Franz Fuerst and Patrick McAllister, “Green Noise or Green Value? Measuring the Effects of Environmental Certification on Office Values,” Real Estate Economics 39, no. 1 (2010): 45–69.
13. Norm Miller, Jay Spivey, and Andy Florance, “Does Green Pay Off?” Journal of Real Estate Portfolio Management 14, no. 4 (2008): 385–399.
14. Sofia Dermisi, “Effect of LEED Ratings and Levels on Office Property Assessed and Market Values,” Journal of Sustainable Real Estate 1, no. 1 (2009): 23–47.
15. “A Green Tour of the Google Campus,” The Official Google Blog, http://googleblog.blogspot.com/2009/10/green-tour-of-google-campus.html.
16. Interviews with Vicky Noonan, managing director, Tishman Speyer, Chicago, Illinois, 2009; Eric Sorensen, 2009; Jon DeVries, director, Strategic Development Planning, URS Corporation, Chicago, Illinois, 2010; and Avi Lothan, principal at DeStefano Partners, Chicago, Illinois, 2010.
17. Interview with Jon DeVries, 2010.
18. D. Anderson, “The Race for Office Space,” Industry Standard, January 11, 2000; and Joe Gose, “How Dot.Coms Pushed Office Markets to New Heights,” Barron’s, June 5, 2000.
19. Interview with Vicky Noonan, 2009.
20. Interviews with Greg Van Schaak, Rafael Carreira, Eric Sorensen, Bill Rolander, and Dennis Harder, 2009.
21. Interview with Allan Kotin, adjunct professor, School of Policy Planning and Development, University of Southern California, and Allan D. Kotin & Associates, Los Angeles, June 2002.
22. Interview with Gabe Reisner, president and CEO, WMA Consulting Engineers, Chicago, Illinois, summer 2010.
23. Full-sized parking spaces range from 8.5 feet wide by 16 feet long (2.5 by 4.9 m) to 10 feet wide by 18 feet long (3 by 5.5 m). Compact spaces are somewhat narrower and/or shorter, while spaces for the handicapped are wider. Two-way aisles for perpendicular parking vary from 24 to 27 feet (7.3–8.2 m) wide. A double-loaded parking module requires a 60- to 63-foot (18.3–19.2 m) cross section for two parking places and an aisle, plus the space required for the structure itself. The simplest design requires a minimum of two modules with continuously ramped floors that provide circulation between levels. With circulation and parking along the ends of the structure, the minimum dimension for the entire structure is about 130 feet by 190 feet (36.5 by 57.9 m). Local parking requirements should be consulted.
24. Interview with Jim Goodell, Goodell Associates, Los Angeles, California, June 1989.
25. Interview with Avi Lothan, 2010.
26. David M. Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz, Commercial Real Estate: Analysis and Investment, 2nd ed. (Cincinnati, Ohio: South-Western Educational Publishing, 2007), pp. 771, 773.
27. Charles Long, Finance for Real Estate Development (Washington, D.C.: ULI–the Urban Land Institute, 2011).
28. Interview with Michael Sullivan, principal at Cannon Design, Chicago, Illinois, summer 2010.
29. Interview with Avi Lothan, 2010.
30. Interviews with Avi Lothan, 2010; and David Eckmann, principal at Magnusson Klemencic Associates, Chicago, Illinois, 2010.
31. Paul Katz, “The Office Building Type: A Pragmatic Approach,” in Building Type Basics for Office Buildings, by A. Eugene Kohn and Paul Katz (New York: John Wiley, 2002).
32. Interview with Gabe Reisner, summer 2010.
33. Interviews with Avi Lothan and Michael Sullivan, 2010.
34. Katz, “The Office Building Type.”
35. Ibid.
36. Ibid.
37. Interview with Gabe Reisner, summer 2010.
38. Interviews with Gabe Reisner and Mike Sullivan, summer 2010.
39. Interview with David Eckmann, 2010.
40. Interview with Michael Sullivan, 2010.
41. Norman D. Kurtz, “Mechanical/Electrical/Plumbing Systems,” in Kohn and Katz, Building Type Basics for Office Buildings.
42. John Van Deusen, “Vertical Transportation,” in Kohn and Katz, Building Type Basics for Office Buildings.
43. Lew Harriman, Geoff Brundrett, and Reinhold Kittler, Humidity Control Design Guide for Commercial and Institutional Buildings (Atlanta, Ga.: American Society of Heating, Refrigerating and Air-Conditioning Engineers, 2001).
44. Interview with Avi Lothan, 2010.
45. Interview with Michael Munson, Metropolitan Energy, Chicago, Illinois, 2010.
46. Interview with Tom McCaslin and John Wong, Tishman Construction Corporation, New York, New York, September 2000.
47. David S. Chartock, “4 Times Square: New York’s First Green Office Building,” Construction News, June 1998.
48. David V. Thompson and Bill McCarthy, “Security Master Planning,” in Building Security Handbook for Architectural Planning and Design, by Barbara A. Nadel (New York: McGraw-Hill, 2004), pp. 2.1–2.30.
49. Interview with Carlos Villarreal, senior vice president, Whelan Security, Chicago, Illinois, 2010.
50. Interviews with Rafael Carreira, Greg Van Schaak, Eric Sorensen, and Bill Rolander, 2009.
51. Ibid.
52. Ibid.
53. Interview with John Newman, former president of the Commercial Banking group of LaSalle Bank N.A. and ABN AMRO North America, Chicago, Illinois, summer 2009.
54. Interviews with Bill Rolander, Greg Van Schaak, Dennis Harder, Rafael Carreira, and John Newman, 2009.
55. Interviews with Bill Rolander, Dennis Harder, and Rafael Carreira, 2009.
56. Interviews with Greg Van Schaak, Rafael Carreira, Eric Sorensen, and Bill Rolander, 2009.
57. Ibid.
58. Interviews with Milda Roszkiewicz and Anthony Frink, Chicago, Illinois, 2010.
59. Interview with Dennis Harder, 2009.
60. Interviews with Lenny Sciascia, director, Tishman Speyer, Chicago, Illinois, 2009; Cathy Stephenson, 2009; and Vicky Noonan, 2009.
61. Interview with Cathy Stephenson, 2009.
62. Interview with Karen Krackov, executive managing director–GEMS, Grubb & Ellis, Chicago, Illinois, 2009.
63. ibid.
64. Interviews with Cathy Stephenson and Lenny Sciascia, 2009.
65. Interview with Avi Lothan, 2010.
66. Interview with Mike Munson, 2010.
67. Interviews with Vicky Noonan and Eric Sorensen, 2009.