Skyscraper Fire Sale

Recently, a 1.8 million square foot building in New York City was purchased for $600 million. That may not seem newsworthy except that the asking price prior to the sale was $1.74 billion. The drop in price could be attributed to a variety of factors, one of which may be that of the 1.6 million square feet available for rent, only half was actually occupied.

A sale price of 65% of the original cost is enough to draw the attention of even the most cautious of investors, but those who are both careful and keen know that there is more to a good investment than a low price. A decrease of this magnitude in the span of two and a half years is an indication that something is amiss.

Just as the rest of the country is experiencing economic hardships, New York City is seeing drops in monthly rental rates and less demand for rental units. With a building that is only half full, as was this building, the investor is most certainly losing money. In the best possible scenario, the buyer would have paid cash for the property, and still the operating costs would be higher than the rental income. The bottom line is that the buyer who thought he was getting a great deal, paid $600 million on a property that will cost more to maintain than the income it will generate.

The overarching question is: What do the new owners need to do to convert their failing office building business into a successful one? The obvious goal is to increase the percentage of leased space from 50% to 95%. Not impossible, but very difficult. Following are some realistic scenarios. Increasing occupancy in 10% increments per annum means it will take five years to get there. To accomplish this, the buyer needs to be prepared to spend a significant amount of capital. These costs will include tenant improvements (TIs), leasing commission, and negative cash flow.

New lessees never say the space is perfect. In weaker markets, lessees are more demanding and the lessor pays. To get to 95% physical occupancy, 360,000 square feet need to be leased. The going rate for TIs is in the area of $125 per square foot. That comes to approximately $45 million.

Leasing agents charge 6% of the rent to be collected for the length of the lease. In a weaker market it might be 5%. If the buyer could get $50 per square foot per annum with a three-year lease, that would amount to approximately $3 million in commissions paid up front.

What makes the negative cash flow fascinating is the impossibility of projecting other than losses will be large. The buyer only hopes that they are not larger than the money set aside to cover them. It will be in the millions per year. The bottom line is the buyer paid $600 million for a failing speculation. Assuming the economy cooperates and concessions aren’t a factor, what can the investor expect? Using the numbers above, and a 6% capitalization rate, the property could be worth approximately $750 million in five years. An interesting side note would be who received the leasing commissions, property management fees, insurance commissions, and capital improvement oversight fees? The real question then might be: Was it a good buy or a bad buy, and for whom?