In this interview, we’ll learn why investing in Silicon Valley could be a good idea, what happened to office spaces during the last downturn, things an investor should cover when looking at purchasing an office, what types of leases are standard for office space, and what does the future of office space look like. We’re interviewing Eduardo Zepeda, he began managing commercial properties in downtown San Francisco in 2008 as a part time property manager for a family office and was instrumental in the expansion of the portfolio. He is now the full time asset manager and leasing director for the group’s holdings, managing north of $100M in combined assets comprised of multi-tenant office and retail property. He’s currently leveraging the knowledge he’s acquired to pursue his own real estate investments as a principal with a focus on light to moderate value add multi-family or small commercial projects in the Bay Area.

Making a case for investing in Silicon Valley: Why do you like this area? 
I didn’t really know at the time, since I was still pretty young, but I was entering this profession during one of the worst recessions locally and nationwide. I’ve witnessed how much the local economy here in the Bay Area has grown over that time, whether it’s in residential, multifamily and on the commercial side as well. One thing that I’ve learned about the Bay Area is that it’s the perfect storm of supply and demand economics where you have a finite fixed amount of land and a very strong demand not only for housing but also for space to occupy, whether it’s office, industrial or just land to develop and improve.

The macroeconomic factors for the Bay Area are very compelling, whether you’re looking for a short term value add project with an exit, or a long term hold, there’s a compelling argument in both cases for investing in this area even during this economic times. The challenges is that prices are very lofty. The environment here is very competitive and there’s a lot of capital that is chasing deals. The groups that really like real estate are willing to transact even in low yields, and low cap rates. It’s challenging on a short term basis because there may not be enough yield to justify a short term hold. I do think that if you’re a long term investor, you’re going to be in a really good position in a few years once you start to realize that cashflow and the increase in NOI, or the increase in value of the property.

What was the vacancy rate like during the 2008 recession and what were some of the major issues that the properties that you were managing were facing? 
My first couple of years was really focused on junior tasks, I was doing a lot of interacting with the tenants, coordinating vendors, sending notices of late rent payments and so forth. On the leasing aspect of it we were doing deals somewhere in the $20’s/year/sf, sometimes even in the high teens and there was a lot of inventory space back then. The demand was pretty low, especially compared to now where the vacancy rate in San Francisco is around 5% for office. The demand didn’t stay very strong throughout, on a rental rate basis it was quite different than what it is now, from $20 per square foot back then.

What are offices charging per square foot nowadays?
It depends on the building type, my area of focus is in downtown San Francisco. Within our portfolio we have multi-tenant, and class B and C properties. Depending on the part of town and the part of the Financial District, or South of Market, anywhere from the high $40’s/sf/year all the way up to the high $60’s- low $70’s for a class B. For a high rise, you can go anywhere from the mid $70’s-low $80’s all the way up to the low $100’s or higher, depending on the building and the area.

What should investors look for when buying an office building? 
If you’re getting started and you’re a mom and pop, or individual, or a family that is looking to get into office, there are many different aspects of an office building, especially if it’s multi-tenant, that you have to be aware of.

Just to name a few:
1. Getting a working knowledge of the building systems: the HVAC , boilers, chillers, electrical, and those types of systems that depending on the way that the leases are structured could be an expense of the landlord, or they could be expensive to the tenant. 2. Having some working knowledge as to the way that they are operating at that property.
3. Have a decent working knowledge as to the different types of leases that are active in the market, or typical for this kind of building.
4. Knowing how to review a lease, knowing the difference between a full service gross lease, an industrial gross lease, a net lease, or any variation thereof. That’s pretty important because it will dictate how much is going to be an expense to you as a landlord. There are provisions in the lease that can allow you to recapture a lot of your operating expenses as well.
5. If it’s a building that has some vacancy, or that has some holes in the leases in the next one to three years – knowing what the market is doing in order for you to able to pretty accurately predict what you’re going to be able to lease those spaces for on a per square foot basis, as well as what the market is doing in terms of tenant improvements. If you buy a building with 10,000 square feet of vacancy, it’s important to know what the market is doing, what other landlords are offering in terms of concessions to fill those vacancies on the retail market. For example, in certain parts of San Francisco such as in the Marina district and Union Street, these high end shopping corridors, landlords can get away with not offering any concessions, or any tenant improvement allowance. But on the office market, it’s not rare to find anywhere from $10 – $30/sf for tenant improvement allowance or tenants buildouts. Having some sort of a working knowledge of that is also very helpful and allowing you to accurately predict what your cashflow for your holding period is going to be.

Can you shed light in terms of the type of leases that the tenants and the landlords prefer?
For Class A and even class B buildings in the Financial District or the central business district of San Francisco, it’s pretty common to have full service gross leases, which means that the rent covers the base rent, the operating expenses, utilities, and janitorial is all provided by the landlord, so it’s kind of an all inclusive lease. That’s pretty typical for Class A and class B buildings that are multi-tenant. That could also present an opportunity, for example, if you’re looking at an asset or a building that is a class B building and all the leases are full service gross, and you’ve had an absentee owner that wasn’t managing all the expenses well, it could present an opportunity for a new buyer to come in and renegotiate some of the vendor contracts, and optimize the way that those operating expenses are being handled. A full service gross lease could present a lot of expenses to landlord, and it could also present opportunity when they’re being mismanaged.

What is a full service gross lease? 

It is when the landlord is paying all of the building operating expenses, including the janitorial and the utilities and all that.

What are some things that an investor should make sure to cover during the underwriting process of an office building?
– It’s important to look at the leases and be able to understand what the recapture ability is going to be, if any, and if the lease has provisions in which the landlord or a new owner is able to recapture. For example, the increase to the basis of the property tax is usually the biggest expense that a landlord that has a full service gross lease building like an office building will have to pay.
– Knowing what your rental projections are going to be for filling any vacancies.
– What’s a realistic number of what the market is doing for this type of product in this location? Talk to brokers that are active in the community, they can give you a pretty good sense as to what that’s going to be. A lot of brokers will readily give that information hoping to work with a new building owner that’s going to be buying an asset. They want to build a new relationship with you in the hopes that you end up working with them to fill those vacancies.
– Look at the operating expenses of the building and look at the historicals: how was the building operated? You want to make sure that those expenses aren’t missing anything that you may want to implement into your operating expenses as well. If you’re acquiring it from an institutional or sophisticated operator or investor, then chances are that their numbers are going to be pretty sound, but if you’re acquiring it from a family, an individual, or an absentee owner, then there may be some operating expenses that they weren’t including that you may want to include in your calculations.

In terms of taxes, I want to highlight that if you’re buying a property from an owner that has owned it for, let’s say a decade, and they bought the property for $1 million back then, and now you’re buying it for $10 million – the property tax base is going to increase quite significantly, especially for some tenants if they’re responsible for it. That’s something that you should always keep in mind and be mindful of for your tenants, and for yourself as the new owner.
If the tenant is sophisticated, or properly advised when they negotiated the lease, this is something that they will often seek protection from. When you are reviewing the leases, you want to make sure that you look through all of them carefully because even if the leases appear like they’re boilerplate template leases, a lot of times there could be provisions that were amended or modified pertinent to that specific lease negotiation. You could have a tenant that has a provision added that they have protection against an increase to the property tax basis if the property is sold. That’s something that could just be included in one lease out of 10, if they occupy 50% of the building, and you miss that one part and you were expecting to be able to recapture a part of that, it could be a pretty significant amount of money that you’re missing out on in that first or two years of operation of your new investment.

It’s always advisable to have an attorney review the leases. Equipping yourself with as many qualified eyes on this legal document as possible, whether it’s an experienced broker in tandem with an attorney that specializes in real estate, this is going to give you the best chance that you can really catch something that could end up affecting you five years down the road during an acquisition when you want to sell or change control of your company. These leases get very specific sometimes with the rights and remedies that a landlord has, even with change of control of a tenant’s company, for example.

What are some things that we as landlords should keep in mind when leasing office space to companies? What are some things that are important to companies when looking for office space? 
The tech industry has been the predominant driver of the economy and with that, the demand for tech friendly creative space has been in high demand. The physical attributes that are highly associated with that are the ceiling height and natural lights. When I first started, we used to be able to lease space with solid walls and standard ceiling height quite easily. Tech tenants are a lot more picky with the aesthetic that they’re after, and there’s a disparity between very similar locations just based on aesthetic alone that a lot of these companies are willing to lease.

You can have two similar sized spaces in identical location buildings right next to each other where one has 8-10 foot ceilings, limited natural light, and the other one has 14 foot ceilings with abundant natural light and there can be a $30% swing in that rental rate that one tenant is willing to enter a lease vs the other. Just based on that alone, I would say that when you’re negotiating on tenant improvement allowance or tenant improvements in general, you can give a tenant improvement allowance in which the tenant conducts a buildout with landlord approval or the landlord can provide a turnkey buildout for the tenant when you’re negotiating on the tenant improvement in general.

Be aware of what can provide residual value in the future. If the tenant vacates at the expiration of your lease or defaults, you don’t want to end up with a space that has low utility to a wide variety of tenants. It’s ideal to have a space that still has residual value – a buildout that can be suitable for a lot of different kinds of tenants. That way it saves you money at the expiration of the lease, if you can reuse the existing buildings for new tenants.

Retail is having a bit of a hard time because people don’t know what is going to happen to retail. What do you think the future of office space is?
In San Francisco and further down South in Silicon Valley there has been an emergence of co-working spaces that are leasing huge blocks of office space. It’ll be interesting to see how that shapes the landscape. I think that the type of tenants that they’re going after are going to be growth companies where they’re able to offer flexibility when the companies may not want to sign a three year lease, which is the minimum that many landlords in this market are willing to enter a lease on.

As far as the rest of the leasing around office space, it’s strong around here and there was a little bit of a slow down in 2016, because people always have their speculations. “Are things are slowing down, where’s the economy going?”. Here we are in 2019 with a 5% vacancy rate in San Francisco. The office market here is stronger than ever. As long as the economy continues to grow and businesses continue to hire and expand, the demand for office space is going to be strong. With the vacancy rate so low, it doesn’t seem that we’re able to even meet the demand with the construction of new office space. It’s hard for me to provide any sort of blanket statement, whether it’s going to be in California, the West Coast or other top tier cities, but I’m pretty optimistic about the office market here in the Bay Area.

Because there is such low supply, where are companies willing to go outside of San Francisco?
Companies are still very much wanting to be in areas where other tech is, which is the core market of San Francisco. The core areas of South of Market, South Park, the East Cut of San Francisco, and the Financial District of San Francisco. So I wouldn’t say that a lot of companies are really getting pushed out.

Is there anything else that our audience should know? 
If you’re looking to get into investing in the office space market, there’s a decent amount of information to learn. Partnering with the right brokers, attorneys, and other professionals that are knowledgeable can be a huge help during the due diligence process, knowing how to underwrite the deal, knowing the different aspects of a lease, what to look for in terms of how it affects the income and the cash flow, knowing how to look at and analyze your expenses, looking at your whole ownership period and how you’re going to increase the income, increase the NOI, fill vacancies, etc.

Partnering with the right people is going to be critical to execute on that plan. Having a sound business plan that is realistic and in line with your goals, whether you’re raising capital to acquire the asset, or if it’s going to be funded on your own. You must have the right team in place to execute the business plan when buying an office building. Working with the right vendors and advisors for all the building systems in order to operate the building and the asset in a way that is going to maximize your net operating income is going to be very important.

Eduardo Zepeda