Office Construction Has Come Back Full Swing

By Gabe Gonzalez

2014 has started off with a bang.  We came back from the annual Mortgage Bankers Association Convention with a myriad of new capital sources that have opened the spigot.  What has been surprising is the velocity of available construction lenders.  DFW and its surrounding municipalities have hit stride by providing better infrastructure and incentives for new development through TIFS and by creating a tax-friendly environment that has attracted large corporate relocations.  Leasing office brokers have changed their outlook substantially from the midst of the recession.  The office market has gotten tight.  Those who were adequately equipped to handle the recession were able to capitalize on opportunities that included favorable office building acquisitions and, now, ground-up construction.

shutterstock_169021919According to Transwestern’s DFW Market Report 4Q , rents in the D/FW Metroplex are likely to increase modestly as local market conditions continue to improve and as demand for space continues.  Asking rents throughout the Metroplex have risen over 1.6% to $21.50 PSF during the past year.  High quality buildings in stronger submarkets will continue to outperform the market-wide averages.  Over the past two years, the demand for office space has outpaced a modest pipeline of new supply. The Class-A office market had a net absorption of 795,000 SF during the 4th quarter of 2013 and a YTD net absorption of 4.2 million SF.  There is approximately 5 million SF of office space under construction or renovation, up from 3.2 million SF in 2012.  Four of the fourteen projects that started during the last quarter of 2013 are 100% pre-leased. Overall, buildings under construction have an average pre-lease of 57%.

Historically, an average office occupancy rate of 85% has been the benchmark that makes new office construction a feasible option.  Strong submarkets such as Uptown have caught the interest of many large investors due to the location, infrastructure, and lack of undeveloped land.  This interest has led to substantial cap rate compression that has priced out smaller investors who seek value-add opportunities.

New office projects are being built by large scale developers such as Granite, Hines and Trammell, who can build projects all-cash or with equity partners at minimal leverage.  So, how does a non-institutional developer find the right capital to make the development feasible?  MCA recently received a loan commitment for a local developer who is seeking to develop a 100,000 SF office building in the West Plano/Frisco submarket.  But, before we began our debt placement efforts, we looked at several essential elements of the transaction that we think are applicable to any proposed office deal regardless of whether the project is in Frisco, Texas, or wherever, such as:

  1. Location – Development must be in the path of progress or a redevelopment in an infill location.  The West Plano/Frisco is the hottest office market next to uptown thanks to corporate relocations and easy access from several major highways.  A tract of land close to major roadways, retail, entertainment, hotels and/or residential can increase the interest of new tenants and ultimately, caught the eye of a Lending Partner.  Developments such as the Legacy Park, International Business Park and Granite Park all have been well-received throughout the years and show the strong appetite by businesses who desire to be in close proximity to their employees and amenities.
  2. Yield-on-Cost – In this case, our client had owned this piece of land for over twenty years, and so they are able to contribute the land as equity based on a recently appraised value.  If you recently purchased a piece of land, the Lender will most likely use the purchase price as the land/equity contribution and not put too much weight on the appraised value of the land.  A favorable land basis will translate into a higher yield-on-cost, which usually translates into more aggressive leverage or loan terms.
  3. Pre-Leasing – This is probably the most important facet of a new office development.  Unlike retail, it can be more challenging to pre-lease an office building for the reason that most businesses do not have the ability to project their demand too far in the future.  This is one reason why office development tends to be spec and done by institutional players who have the balance sheet to fund the entire development, then refinance once the project leased.  MCA’s placement objectives were twofold; first, determine the amount of preleasing required by various lenders to fund the loan, and then, find the appropriate capital.  The general consensus from lenders was that they wanted sufficient preleasing to at least cover the debt service of the exposed loan amount.  MCA found a provider that was willing to start construction with only 35% of the building “pre-leased.”
  4. Experience & Financial Wherewithal – Our assignment benefited from having an experienced office developer with a good balance sheet who had the ability to provide a meaningful construction completion guarantee.
  5. Parking, Parking, and MORE Parking – Successful projects are providing parking for the “high density” office, such as call centers.  Capital Providers want to see high parking ratios on new office projects.

There is more capital than there are deals, making a new development very attractive to investors and creating leverage for the developer.  MCA has been active in placing capital for new developments and has the expertise to analyze your proposed development and to offer the capital solutions required to begin construction. For further information or to discuss a potential transaction, contact any one of the Senior Directors in our Dallas or Denver offices.  www.metcapital.com

Posted on by Scott Lynn in Commercial Real Estate Finance Comments Off on Office Construction Has Come Back Full Swing