We avoided office for years. Until August 18.

Hi {{first_name | there}},

Each Tuesday, I send a short note on commercial real estate to help you be a better investor. Topics may include deal stories, how I'm thinking about risk, lessons I'm learning, and market observations as we oversee our $500MM+ CRE portfolio and serve our 1,100+ investors.

For years, there was one major commercial real estate asset type we avoided:

Office.

The reason was simple. Pre-COVID, we were focused on mobile home parks and self-storage. Post-COVID, there was just too much carnage.

Work-from-home changed demand. Buildings lost tenants. Values fell. Financing options dried up.

Earlier this year, we began looking more closely at the office sector, as we believed there might be compelling risk-adjusted return opportunities.

On August 18, we invested $6 million to acquire a Class A ~123,000-square-foot office building in downtown Decatur, Georgia (pictured below), in the Atlanta MSA. 

The investment is in our Wellings Real Estate Income Fund, which is closed to new investors.

And to be clear, we did not make this investment because we think office is "back" across the board, and we do not intend to make office a large portion of our overall portfolio.

Here are three primary reasons this deal got through our filter.

We weren't interested in office simply because prices had fallen. Something being cheaper than it used to be doesn't make it a good purchase.

This property was acquired for approximately $18.5 million, or about $150 per square foot, at an ~11% cap rate based on trailing NOI after replacement reserves.

For context, CoStar estimates current Decatur office pricing at approximately $185 per square foot.

We also spoke with a seasoned, local Atlanta office broker who had no involvement in this transaction. Based on current market comps and assuming the property reaches ~90% occupancy, he estimated that a mid-8% cap rate would be reasonable.

Those comparisons aren't proof of value. Different buildings have different occupancy, leases, capital needs, and quality. But they give us good data points for the basis.

We care deeply about what we have to assume on the exit to achieve our projected returns. Our underwriting assumes a 10% exit cap rate five years from now. 

In other words, our projected return does not depend on buying at an 11% cap rate and selling at a 7% cap rate.

National office headlines have been ugly. But office tenants don't lease "national office."

They lease a specific space in a specific building in a specific submarket.

The Decatur office submarket has an office vacancy rate of approximately 7.6%, with no new office space under construction, according to CoStar.

Our building, meanwhile, is approximately 22% vacant.

So why is one of the better office buildings in a tight submarket so far below market occupancy?

Based on our due diligence, we believe that the gap was seller-specific. The seller was facing pressure from fund life termination, had limited capital available for tenant improvements and leasing commissions, and was under pressure from its lender. 

In other words, the seller did not have the necessary capital or time to get vacant suites tenant-ready and leased.

That creates the opportunity...but it also creates execution risk.

The building is in walkable downtown Decatur, an affluent submarket with a MARTA rail station. The property has 22 tenants across legal, medical, financial, government, nonprofit, and other professional-service uses.

Our thesis is that fresh capital and focused leasing execution can close some of the gap between the property's 78% occupancy and a much tighter surrounding submarket.

Our operating partner has focused on office for 37 years and has completed approximately $2.6 billion of transactions.

They also previously owned this exact building.

During their prior ownership from 2011 to 2015, they increased occupancy from approximately 67% to more than 90%, and ultimately generated a ~20% gross IRR.* 

The same asset manager who oversaw the building during that ownership period is managing it again today. And about two-thirds of the current tenants were already in the building when our operating partner last owned it.

Past performance obviously doesn't guarantee they can repeat the result.

But there is a meaningful difference between partnering with someone who says, "We know office," and someone who can say, "We've already operated this same building successfully with many of the same tenants."

Tenant rollover, renewals, and demand from new tenants. Roughly half of the building's square footage is scheduled to roll from 2029 through 2031. 

Office leasing is also expensive. We are budgeting approximately $5.35 million for leasing commissions, tenant improvements, and property upgrades over the hold period, a meaningful amount relative to the $18.5 million purchase price.

When an investment is in an unpopular sector, I would ask:

1. Does the deal work without the broader market improving?

2. What objective evidence shows that the price is attractive and the deal works today, rather than simply being cheaper than before?

3. Does the operator have specific experience solving the problem this investment requires them to solve?

If you have feedback or there's a topic you'd like me to cover in a future newsletter, reply to this email. I read every response!

All the best,

Ben Kahle

Managing Partner | Wellings Capital