An Intro to Commercial Real Estate: Through an Architecture Lens

An Intro to Commercial Real Estate: Through an Architecture Lens

Having spent the last 10 years working on the design and construction of large-scale offices and mixed-use private developments, I knew surprisingly little about how owners and developers go about evaluating potential projects for their portfolios. To better understand the business decisions of the owners and project managers I work with on a daily basis, I sought out a course to educate myself on the financial and investment arm of development. Through the Urban Land Institute, I found a bundle of four courses focused on financial literacy, market analysis, and financial modeling. Upon completion, I received a Principles of Real Estate Finance and Investment Certificate. As part of the WRNS Studio Scholarship Fund, I’m sharing this report for the benefit of others at the firm.

It’s clear that the pandemic, inflation, and rising interest rates have had a profound effect on the real estate market but I wanted to use this opportunity to educate myself in general on financial terminology and apply the concepts to our local market. I took the four courses in the following order.

  1. Introduction to Real Estate Finance and Investment
  2. Introduction to Real Estate Capital Markets
  3. Pro Forma Modeling 1
  4. Introduction to Market Analysis

With the understanding I gained from the course, I started to dig deeper and ask myself some questions. What do the numbers show year over year?  What are the trends? And where is the market heading in 2024? Hopefully, the data will shed some light on the real estate slowdown we’ve felt over the past few years and why owners and investors have been hesitant to spend in the current market.

There are many investment terms that go into evaluating whether an opportunity is worth pursuing, for this report, I am going to dive into four: 1. IRR (Internal Rate of Return) 2. NOI (Net Operating Income) 3. Cap Rate (Capitalization Rate) and 4. Discount Rate (Required Rate of Return). As we get into the analysis we’ll define and apply them.

Cap rates are a general indicator of market conditions and project value. It’s generally derived using market data and sale prices for actual property transactions by dividing a project’s NOI or Net Operating Income by its value. A high cap rate is associated with lower property values and low demand from investors as well as low appreciation potential. A low cap rate indicates the opposite: high property value, high demand, and high appreciation potential.

Below you’ll find a graph showing national cap rates from 2001 to 2022. Minus the bump during the Great Recession of 2009, Cap Rates had been declining steadily until 2020 when the effects of the global pandemic started to hit the market. Declining Cap Rates coincided with declining interest rates which led to more development. Some of WRNS Studio’s most active years in the office market were 2015-2020 with projects like Santana Row, Ameswell Mountain View, and Elco Yards Mixed-Use Life Sciences as well as our work with Microsoft, Intuit, and Meta. Owners and developers were keen to take advantage of low interest rates and debt financing as well as the high demand for commercial real estate, especially in the Bay Area.

Commercial Real Estate Cap Rates, Q1 2001 – Q4 2022

Source: CBRE – Connections and Disconnections of Cap Rates across Property Types – January 2024

Office Cap Rates – 2023

Source: CBRE – United States Cap Rate Survey H2 2023 – March 2024

As you can see from CBRE’s 2023 Cap Rate Survey, this chart shows the rate continuing to rise through the end of last year. The Cap Rate for Class A offices in San Francisco is about 7.25%. There are a lot of factors that contribute to this rise; high interest rates, work-from-home policies, and the increase in online retail, to name a few. But if you apply those numbers to a theoretical investment in 2019 compared to today the returns are quite staggering.

Project Value = NOI / Cap Rate.

A theoretical project with a NOI of $10,000 in 2019 with a Cap Rate of 4.25% has a value of $236,000. That same project today with a 7.25% cap rate has a value of $138,000.

The boom in development leading up to the pandemic increased the supply of office space in the market. Combine that with the onset of remote work and now we see market vacancy climbing. Over the past three years, the Bay Area has seen some of the highest vacancy rates in the country. Back in 2019 vacancy rates were at 6%. That has now climbed to 19% at the start of 2024. High vacancy rates also signal low net absorption rates which is a change in the quantity of occupied space and in essence a reflection of the demand for office space. As demand decreases, prices or rent in the office market decreases. Ever so slight variations in assumed rent or cap rates can have a significant impact on the IRR (Internal Rate of Return) which is an estimate of the profitability of a potential investment. As returns drop so does the appetite for investment.

Net Absorption and Vacancy Rates 2014 – Q1 2024

Source: CBRE – Snapshot – Silicon Valley Office – Q1 2024

Any investor evaluating a project would create a Pro Forma which is a financial model evaluating the potential return on the investment. The pro forma will take into consideration; project size, rental rate, purchase price, expenses, vacancy rate, growth rates, interest rates, and cap rates. The first step in creating a pro forma is to plug in all of your project assumptions. The next step is to estimate the project’s NOI (Net Operating Income) over the holding period which is how long you estimate owning the property.

NOI = Effective Income – Operating Expenses – Taxes

Once we’ve calculated the NOI we can determine the project’s cash flow by subtracting the debt service. And with the cash flow, we can determine the IRR. Let’s put it all together to determine if the current market conditions provide a favorable investment opportunity. For the sake of comparison, we’re going to keep all variables the same for a sample project and adjust the following to determine the IRR; Vacancy Rate, Interest Rate, and Cap Rate. Here’s a chart showing the average mortgage rates over the past 5 years.

Average 30-Year Fixed Rate Mortgage

Source: Freddie Mac – Primary Mortgage Market Survey

Let’s use an example from last January: 303 Bryant Street, Mountain View. CA. This 56,000 sq ft office building sold for $36.0 MIL. Let’s assume you can get $55 / sq ft in rent and you plan to hold the property for 5 years.

Here are the numbers we will use. 

Cap Rate – Jan 2019 = 4.25%

Cap Rate – Jan 2024 = 6.25% (Even though the current cap rate is above 7% currently in San Francisco let’s be optimistic and hope that in 5 years, the demand for office space has started to rebound.)

Interest Rate – Jan 2019 = 4.5%

Interest Rate – Jan 2024 = 6.6%

Vacancy Rate 2019 = 6%

Vacancy Rate 2024 = 19%

Here’s the Pro Forma calculating the IRR in 2019. (The pro forma Excel outline was given to the course participants. There are functions built into the cells to calculate the various results. I won’t go into the formulas but if you’re interested, ULI’s Pro Forma Modeling 1 is a great course to familiarize yourself with building and testing a project pro forma.)

Here’s the same Pro Forma calculating the IRR in 2024. 

This analysis is not meant to encompass or touch upon all of the factors that need to be considered when making real estate financial decisions. Plus it’s not entirely accurate to assume the same sale price and rent assumptions five years apart but the point here is to show you how big of an impact Cap, Interest, and Vacancy Rates alone have on the investment return and why the current market conditions don’t provide a favorable outlook on real estate investments. With a 16% IRR it’s clear to see that the market conditions leading up to 2019 were far better than what one could expect today. However, it’s worth noting that while Cap Rates and Pro Formas show the numbers, many other factors need to be considered when making a real estate investment; capital markets, location, size, amenities, and job growth to name a few. A great location and growing job market could change the outlook considerably.

So where does this leave us?

Well, there’s hope that interest rates will go down, employment is trending upwards, and return to office is gaining momentum which should bring down the vacancy rate. It still may not be the right time to make new investments in commercial real estate but rather hold existing assets until the market corrects or rebalance your portfolio. While demand is currently staying relatively flat we are seeing clients start to “right size” or evaluate their current office space needs to adapt to the new hybrid work environment. Another hot topic these days is office-to-residential or office-to-life science/lab conversions. Not every commercial property is a suitable candidate for a residential switch but those with smaller floor plates, shorter window-to-core distances, and proximity to amenities should at least be considered. Industrial properties are also growing in value as demand for warehouse space increases with the growth of online retail and requests for shorter shipping times. Amazon Prime free next-day shipping!

All in all, I can’t say enough good things about ULI and the courses they offer. I learned a tremendous amount about real estate finance and market analysis and would highly recommend anyone interested in learning more to consider the certificate. And when the market rebounds you’ll have the knowledge and resources to understand why.

ULI Learning