What constitutes the difference between a Class A property, a Class A-/B+ property (sometimes referred to as Class A1 or A Prime), a Class B property, and finally, a Class C property? Sounds like a silly question for a real estate investor to be asking, no? Unfortunately, I’m being serious.
Recently I was helping an analyst in our New York office analyze some of the underlying collateral of several different CMBS loans. During the conversation he told me that there were three “Class A-/B+” buildings in downtown Dallas about which he wanted my opinion. Once he told me which buildings he was referring to, I could not help but laugh—not because he was looking at the debt on these buildings, but because in their current state, I see no rational way to include them in the Class A-/B+ category.
To illustrate my point I’m going to use Bryan Tower as the test case. (As many of you know, my firm owns Bryan Tower, so there is no risk of offending anyone.) First, I went to the quarterly reports put out by three of the larger real estate brokerage firms operating in downtown Dallas. Although I admit I had to make a few calls to the firms to confirm my hypothesis, all three put Bryan Tower solidly in the middle of the Class A-/B+ category. I then confirmed that they put the other three properties mentioned above in the same Class A-/B+ category. None of the people I talked to at the three firms could give me any of the specific criteria used to make the classifications.
(If you are wondering which buildings I’m including in this set of three, I have purposely not disclosed their names. There are two reasons: First, I don’t want to risk breaching any confidential information that may have been disclosed to me, and second, I see no reason to name names—my points are not enhanced by embarrassing these building’s ownerships. However, I assure you that all building information in this blog is derived from either CMBS documents or my personal knowledge of Bryan Tower.)
Test case: Bryan Tower
Bryan Tower currently has just over a 20 percent vacancy rate; in other words, we are just under 80 percent leased. Over the last five years we have increased rates, had stable occupancy, and were able to refinance our mortgage at a higher principal amount and lower interest rate (roughly 18 months ago). Bryan Tower has a much better than average parking ratio for Class A-/B+ buildings and is located just a few short blocks from the Arts District. Bryan Tower has never defaulted on its loans and has always made its coverage ratios. We have one of the best property management teams, and have always believed in and paid for preventative maintenance. Finally, our renewal rate far exceeds industry averages.
On the last two points I understand if you may be hesitant to take my word for it; after all, I take great pride in our Spire properties. That said, I’m confident that if you asked any qualified downtown broker about my claims, they would concur.
Test Group: Three Downtown Office Buildings
These three properties are ranked in the Class A-/B+ category by all three brokerage firms. Without breaking down the specifics of all three buildings, let me share their similarities. All three have seen a rapid decline in occupancy over the last five years (at a minimum). When factoring in tenants that have announced they are leaving, all three buildings are under 40 percent occupied. All three have had foreclosure proceedings pursued against ownership. None of the three have made coverage ratios in over two years (some much longer). If you add the preventative maintenance disclosed in their CMBS filings, the three buildings combined spent less than Bryan Tower in both 2012 and 2011 (I believe this is true for 2010, but the filing information, for this category—on one of the buildings in particular—is fuzzy for that year).
These are the facts as laid out by the loan servicer’s documents. Some additional facts are as follows. All three buildings command lease rates significantly below Bryan Tower; based on most recent comparables, they lease for a 24 percent-33 percent discount. Only one of the three is anywhere near the Arts District.
Here are a few more important factors that follow logic and history. First, a building that is not making its coverage ratios has to save money somewhere; this usually comes out of management and maintenance. It is not clear that any of the three owners have the means or desire to pour more equity into these struggling buildings. After all, because all three are under water, who would want to sink more money into the building without some assurance that things would change as a result? This leads to a vicious downward cycle of disrepair for the building. Second, in the current tenant market, how will these buildings command rates that won’t further their financial decline?
Downtown Dallas is an extremely competitive market and both brokers and tenants are aware of the problems these three buildings are having. It will be hard, if not impossible for these buildings to convince the market that they are a good long-term bet for the tenant.
Now that I have laid out the facts for you, I come back to my original question. Why do three of the largest brokerage firms rate these four buildings in the same class? We now know that it is not about location, financial condition, physical condition, rental rates, management, or future economic trends. So in what world, financial or other, do these four properties compete, and therefore warrant the same rating?
