Advice please, commercial office condos

[dsachs1]

I have been looking into some office condos for sale. There are two buildings with 4 units in each (8 units total). All units are currently leased (NNN). All tenants have stellar credit. The seller is using a 7.5% cap rate. My issue is that while there are 8 units, only 4 tenants. For two of those tenants their lease expires in 2010. The other two tenants have the option to terminate their lease in 2010, but if not, it expires in 2012. I feel the risk premium in the cap rate does not reflect the potential that the owner could have 100% vacancy in 2010. While that is unlikely, all the tenants have only occupied the building for around 5 years.

Do you feel 7.5% is an appropriate cap rate? If not, what would be?

Thanks!

[Tim]

Where are these located?

I have to tell you, I would not even consider a CAP rate that low.

Most of the ones I consdier are in the 9.5 to 10.5 range and it has to be an EXCEPTIONAL property for me to consider a CAP rate below 10.

In general, a "risk premium" would drive the CAP rate higher, which drives the price lower.

[dsachs1]

The condos are in upstate NY. I was thinking of offering a 10% cap rate, but I still wonder if that "risk premium" doesn't really take into effect that 2 of the 4 tenants lease expire in 2010 and the other two have the option to terminate in 2010 (if not their lease expires 2012). I personally feel I would be taking substantial risk around 2010 when the tenants decide whether or not to continue their lease...especially since this deal would be financed.

Thanks again.

Dave

[Tim]

Well, you don't offer a cap rate, you offer an amount you are willing to pay for the asset. You arrive at that number by understanding the current, verified, NOI of the building as it stands now and apply the cap rate you deem acceptable considering everything you know about the market.

I want to touch on your fear of what will happen in 2010. Are you afraid if those tenants leave NO ONE will want to rent there? If so, why? And if you really believe that, why would you even consider the building?

When I look at commercial buildings I look at it two ways. The first is what is it worth, right now, today, the way it is currently being run. In other words, what is the NOI?

Then, I figure out the CAP rate I need taking into account my financing options and required profit margins.

Then I arrive at a ballpark price for the asset, as it sits, now.

At the same time, I am looking to see what I can do to increase the NOI over some reasonable period of time. Yes, that means I look for buildings with below market rents and low NOI because they are not managed well. I put a plan together to make changes and improvements to reduce costs AND increase income. That increases the value of the asset should I decide to sell or refinance.

[dsachs1]

I grew up in the area so I do feel I have better knowledge of the market than most other places. Yet I work in NYC, very far from the current listing. I am looking to get involved with commercial real estate, but want to take on a more passive management role. I am constantly busy with my current line of work and don't really feel I would have enough time to take an active role in creating more value in the property. I want to look for long term NNN leases with very reputable companies. These type of properties will obviously involve lower cap rates than ones that involve rehabilitation, but there are still lots on inherent risks that go along with even a passive investment with stellar tenants. Risks that to me are worth more than a 7.5% return. You take into effect the average cost of debt and inflation, and your still looking at a negative real return (excluding capital appreciation). My benchmark of risk is the 10 year note. Knowing that I can get a risk-free yield of around 4-4.5% from the US government makes me feel that 8 units located in upstate new york occupied with great tenants stills deserves more than a 350bps premium. I still want to look for good under valued investments.