SB Equities

This week, the owners of 200 Public Square (formerly known as the BP Building) put the building on the market for sale.  I was on the team that sold the property to the current owners back in 2005 so when my friend from the Plain Dealer, real estate reporter Michelle Jarboe, called to ask my opinion, I wasn’t at a loss for words.   Michelle wrote a nice piece (click here to link) but it was one of the comment posts online that really caught my attention.  I’ve copied it below:

newman writes: “The building will sell for about $145 – 155 million. That equals about $130/sf. Class A buildings here will sell between $125/$150 per square foot max. The math is 1,200,000 square feet at roughly $24.50 per square foot and then take a vacancy factor of 10% (at least), then subtract out the building operating expenses of approximately $12.50 per square foot and then divide that by 7.75% or 8.0%. It’s somewhere in that neighborhood or range. If I’m off by 5%, it’s because i don’t know the actual numbers. There’s just not a lot of upside to the building because rents won’t be able to rise. The building is full and a lot of other buildings need to fill up, and one tenant could easily leave which would kill the value of the building. I hope it does sell, but it will only sell for what the prevailing market returns will allow, and that is different for New York versus Washington DC versus Cleveland.”

I don’t know who newman (Mr Newman, Ms Newman?) is and I don’t disagree with many of the thoughts that are laid out.  However, there are a few fundemental pitfalls in his/her statements as well.  Let’s talk about the good parts first.  Newman’s valuation model is a classic CAP rate analysis.  This model starts with gross potential rental income, adds in any additional income and then subtracts a vacancy loss factor and any operating expenses borne by the landlord to arrive at Net Operating Income (NOI).  It then applies a capitalization rate/return requirement (CAP) to NOI to determine a property value.   This model has been used by investors for decades and for good reason – it’s simple and it considers market rents, vacancy, operating expenses and market CAP rates.

Newman also acknowledges two critical factors.  First, he states that there is limited upside because rents won’t be able to rise.  A great point – one that many an investor that has come to town, guns blazing, has painfully learned (hello, Duke, hello, First Industrial, hello, MetLife, are you listening?).   And second, he acknowledges that investors will NOT chase return or buy on the if-come in Cleveland, as they will in NY or DC.  

Now, onto some of the pitfalls associated with newman’s logic.  As I said, a CAP rate analysis is useful because it’s simple.  But when applied to a building as complex as a 1.2 million square foot multi-tenant office tower, things can get quickly unglued.  I have to go no further than the first number, gross potential rental income, to illustrate my point.  $24.50 psf represents the ‘asking’ rate and, just like MSRP on a new car, this is simply a starting point.  The actual rental rates are different (ie lower), some by a little, some by a lot.  Also, a CAP rate analysis is a snapshot in time but in reality, the remaining duration of the leases will vary widely – some expiring this month and some expiring next decade, with everything in between.  A CAP rate analysis assumes a static income, with no consideration of roll-over and the resultant time and cost to re-tenant, not to mention changing rents over time.  While I’m on the subject of income, there is also no consideration given to additional income.  The building includes a 757-car parking garage.  At an average of $200 per spot per month, that’s an additional $1.85 million of gross income.  There are also a whole host of additional income line items associated with this property – cell antenna leases, electric mark-up (the building buys its electricity at a bulk price and then re-sells it at retail, a common practice among downtown buildings), even an agreement with CEI to NOT run its backup generator that results in a 6-figure income a year.  On the expense side, $12.50 psf feels heavy – I’m assuming they run this building for at least a dollar a square foot less.  I use the word ‘assume’ with great emphasis and therein lies the danger of estimating value without seeing the actual numbers.  Sure, you can make a best-guess estimate as newman did but unless you are basing value on real numbers, it’s all just a shot in the dark, maybe 5% off, maybe 25% off..  And this whole ball of wax ignores the impact of financing (or lack thereof).

But here is the thing that really gives me the willies – implying a CAP rate.  A CAP rate is the result of a property’s NOI divided by its sale price – ie a by-product that represents a completed transaction.  In a fluid, open market, it is common practice to take an average of these by-products, apply them to the NOI of a current property for sale and imply a value.  But our current real estate market is anything but fluid and open.   So picking out a number like 7.75% or 8% is fraught with risk, as it has no current basis.  In fact, this was an issue when trying to determine value in 2005 – a time when the investment market was raging.  Finding a set of comparables from which to draw a conclusion back then was a challenge, as there just weren’t a good sampling of trophy Class A office towers that had sold in second tier markets.  Imagine the challenge today. 

So now that we’ve chased our tail around a few times, what do we know?  He is what I know – Harbor paid $141 million for this asset in 2005, which equated to an 8.4 percent CAP.  Six years down the road, they have stabilized the property and see the exit door sliding open.  And while I’m sure they have enjoyed a healthy dose of cash flow from operations along the way, I’m equally sure that the broker isn’t bluffing when he says they have no intention of selling for a loss.  After considering closing costs and a fair profit, I’m seeing a most likely acceptable sale price of $150 to $155 million.  And what was newman’s value conclusion?  Funny how things work sometimes.