Thursday, May 07, 2009

Cap Rate Indicator?
There was a good article in yesterday's Wall Street Journal about a building for sale in Los Angeles and how its cap rate may be a market indicator. The building is:

Viewed as one of the city's premier office buildings, the 992,000-square-foot glass-clad One California Plaza in the tony Bunker Hill neighborhood was put on the block in January by Macquarie Office Trust, a battered Australia-based real estate investment trust.

The property was acquired in 2006 for $325 million. Real estate experts expect it to attract bids or $200 to $240 million. This is based on the property's current net operating income and a $240 million sales price would translate to a cap rate in the 7.5% to 8.0% range. The article details that the building is 78% leased, has "a number of leases are set to expire over the next few years," which include a bank that occupies nearly 8% of the building's space. The property's debt matures next year. The low occupancy, expiring leases and maturing debt add uncertainty for any buyer that would reflect in a higher cap rate than if the property was stabilized. This property has value-added characteristics, despite its tony location and high profile. Based on this data, I am not sure whether the cap rate would indicate a new benchmark.

To me, the big questions are what lease rates the vacant space is attracting, what concessions and tenant improvements are potential lessees demanding, and who is going to pay for these in a deleveraging economy. By the last point I mean that if the the current debt matures next year, and the property was acquired in 2006, there is a chance that there is little equity left for the seller. The loan was probably interest-only so no principal has been paid down, and if the leverage rate was 75% or more, at a prices lower than $240 million there is no equity for the seller. It would be difficult, if not impossible for the seller to give a credit for leasing expenses. A buyer and a new lender would have to determine appropriate reserves for leasing contingencies. This deal will likely turn on the assumptions for that vacant space. The lease rates for the vacant space may be more of an indicator than the building's final cap rate.

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