The historical norm in office investment is a flight to quality. Typically, a premium has been paid for brochure quality assets with “credit” tenants. At the top of the last cycle, I would estimate a minimum of a 150 basis point cap rate premium was paid for Class A assets over B.
Adler Group’s core competencies are the acquisition and operation of multi-tenant, management intensive Class B office and flex space. For decades we have been on the front lines, working with investors to optimize the value of these assets. We have always believed that focusing on smaller, entrepreneurial tenants, allows us to more consistently maintain higher occupancies and raise rents. In addition, we believe our credit risk is mitigated by the size and diversity of these tenants. In our properties, typically there is not a single tenant whose default or non-renewal would cripple our occupancy and therefore inhibit our ability to pay debt service. In addition, we believe that in this current economic climate, tenants will gravitate to Class B space as a cost saving measure.
Smaller entrepreneurial tenants tend to be more rooted to their location. Often, large national companies make decisions having little to do with local operations. For example, in difficult times, national companies are more likely to merge their Orlando and Tampa offices into one. Smaller tenants tend to live within a few miles of their office and employ multiple family members. Their size makes it harder to downsize their space. Large companies can have layoffs and shrink from 20,000 to 10,000 square feet. It is hard to downsize when you only lease 2,000 feet and your employees are relatives.
I am not saying that we are without defaults or downsizing in our portfolio but generally we have seen our entrepreneurial tenants fight on because they have limited options. Their business is literally what puts food on their family’s table.
Today, there is growing awareness of the advantages of Class B office within the investment community. Inherently, new office buildings are Class A. In Downtown Miami and Brickell there is over 1.5 million square feet of new office towers set for completion in the coming months. New buildings, typically do not encourage smaller tenancies and therefore have less effect on Class B buildings. In addition, there is less allure to large “credit tenants”. Some of the largest and most prestigious companies in the Country have gone into bankruptcy’s causing additional Class A vacancy.
Finally, the amount of money one needs to invest in Class A leasing is discouraging investors, who are currently more focused on immediate cash flow than they have in the past. Class A office tenants generally demand significant tenant improvement allowances to build out their space, while Class B tenants require far less improvement allowance. In our space we often just provide new paint and carpet. This makes the recurring annual reinvestment in the space far less on a percentage basis.
There will always be an investment market for Class A office. However, I believe the premium many were willing to pay for Class A is diminishing and there is starting to be a recognition to the benefits of Class B. The one challenge with Class B office space is it remains management intensive, but strong operators with expertise can provide an attractive return.
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