As the creative office phenomena continues to spread throughout markets across the West Coast, we evaluate the lending trends developers are subject to when converting older buildings to creative office. Although creative office has been around for decades in various forms, the inventory has been increasing dramatically since the Great Recession. Starting with technology companies and spreading into more traditional FIRE (finance, insurance and real estate) tenants, the open work space creative build-out continues to grow in popularity to attract younger workers.
Landlords have found that the space and amenity needs for tenants is changing and that having more collaborative space, outdoor areas and walkable amenities are no longer a perk but a must in attracting the best talent. Therefore, many landlords are renovating their buildings to meet the demands of today’s tenants.
Unfortunately, attributes inherent to creative office space are difficult for lenders. Renovated projects are usually from older office or industrial product, so there is a vintage issue. Landlords also put large capital improvement dollars into the renovation to make the space look like new, which helps them achieve top-of-the-market rents, but can also cause their basis to be higher than traditional Class A office product. Lastly, creative office typically has non-credit tenants paying rents that are difficult to comp.
The standard creative office reposition is usually done on a speculative basis, meaning periods of no tenancy or income. Banks continue to struggle to finance vacant buildings on a non-recourse basis, so we have seen more and more debt funds and specialty finance lenders step in to fill the gap. This means that you need to approach a variety of lenders to understand your options. The economics between banks and alternative sources of capital are stark. If you can get a bank interested then the financing is likely within the ±55 percent loan-to-cost range with pricing in the low 300 over LIBOR range, and often has an element of principal repayment guarantee. If you miss with the banks then a typical debt fund execution will be in the ±65 percent loan-to-cost range, however pricing is typically north of 450 over LIBOR, although guarantees will be limited to a completion guarantee.
Upon stabilization, CMBS lenders tend to be a great source of longer term capital for creative office buildings due to the higher price per square foot requests and roll-over schedules of non-credit tenants. Low turnover costs help lenders get more comfortable with potential near term roll and/or more speculative credit on tenants.
The final takeaway is that you need to go wide on these opportunities and be sure you are talking to all relevant sources of capital. Although it’s difficult to get banks to do creative office conversion loans the economics are compelling enough that you can’t overlook them.
Jordan Angel is a director in the San Francisco office of HFF with more than 15 years of commercial real estate experience. He focuses primarily on debt and equity placement transactions throughout the western United States.
Mr. Angel joined the firm in March 2014. Prior to joining HFF, he worked most recently as an executive director at Barry Slatt Mortgage Company. He has secured billions of dollars in debt and equity for retail, industrial, office, multi-housing, mixed-use and other commercial property types.
Jeff Sause is a director in the Los Angeles office of HFF with more than eight years of experience in commercial real estate. He is primarily responsible for sourcing, underwriting and closing debt and equity investments for commercial real estate owners and developers. Mr. Sause has completed 129 transactions totaling nearly $2.8 billion of capital during his time at HFF.
Mr. Sause joined the firm in March 2011 as an Analyst. Prior to HFF, Mr. Sause worked on an investment sales team and as a research analyst at Cushman & Wakefield in Los Angeles. Mr. Sause grew up in Los Angeles, attended Loyola High School and then the University of California at Berkeley, where he received a bachelor's in Economics.
This article originally appeared in Western Real Estate Business's February issue.