What’s the best way to scare a lender? Tell him you want to invest in Class B offices.
But to Doug Agarwal, the Class B market is no joke.
Agarwal, the founder of Austin-based office investor Capital Commercial, has built a lucrative business by buying low where most would be scared to buy at all. Over the past three years, as the office market has melted down, Capital Commercial has emerged as the top buyer of aging office properties in Texas.
Since 2020, the company has spent $650 million on more than 5.5 million square feet of offices across the Sun Belt, focusing on value-add deals in suburban markets. It turns what it calls “End-of-Corporate-Life Campuses” into Class A competitors and finds new strategies to fill them back up. (Class B is enticing developers in Dallas-Fort Worth, too.)
One of its biggest bets is the former headquarters of JCPenney at 6501 Legacy Drive in Plano. Capital Commercial bought the property in 2021, near the nadir of the pandemic office blues, for about $385 million, almost $214 per square foot, according to CoStar News.
At 1.8 million square feet, it has as much space as One Vanderbilt, the second-tallest office building in Manhattan. But it’s just three stories, sprawling out near a greenish-blue pond on 44 acres amid some of the fastest-growing suburbs in the nation. JCPenney moved back in, taking a much smaller space at the property, which Capital Commercial renamed CALWest.
To be a contrarian investor is to bet against conventional wisdom, and there’s no wisdom more conventional in real estate right now than that Class B offices are risky. Capital Commercial has been profiting off this risk since the 1990s, often pulling in double-digit rates of return. Now others may finally be getting hip to the market.
“I know we’re at the bottom because I just got outbid on the last four deals I tried to buy,” Agarwal said. “One of them bid $1 million higher than I did. There are more buyers than there were six months ago, when I was the only guy.”
Taking flight
When “Beavis and Butthead” creator Mike Judge filmed his 1999 cult comedy “Office Space,” he needed settings full of dreary, sprawling office campuses that drove white-collar workers mad with boredom. He found them in Austin and Dallas.
The film’s depressed office workers trudge through spaces so sterile they seem hostile to human life. Flat fields of grass, all the same shade of green, roll into endless parking lots.
Those boxlike offices of sand-colored brick and mirrored glass were ugly even in the ’90s, but at least they were occupied. Then they emptied out. Downtowns across the country cleaned up, welcoming company headquarters back. That left suburban offices on unsteady ground when the pandemic pounded office usage across asset classes.
Since then, brokers and developers have flung around the term “flight to quality” like a security blanket. Sure, entire office buildings sit empty, but ours has a recreation deck. It’s Class AA. It’s a trophy.
“There are more buyers than there were six months ago, when I was the only guy.”
The flight to quality may not be false, but it’s often overblown. The vacancy rate for Class B offices in Austin is actually five percentage points lower than that of Class A, according to the most recent report from CBRE.
That’s complicated by the fact that Class A vacancy rates rise whenever new buildings hit the market, according to Casey Ford, executive vice president with CBRE in Austin. Indeed, last quarter, three developments spanning nearly 1 million square feet came online in the city.
Absorption, which compares how much space tenants took with how much they left, corrects for the volume of new space. In Austin’s Class A offices, a mere 65,000 more square feet came off the market than was added last quarter. Class B absorption was relatively flat.
Even the finest new office buildings are struggling to find tenants. In Austin, the two most significant office developments in recent years are completed but empty. The 589,000 square feet of office space at Sixth and Guadalupe, Lincoln Property Company and Kairoi Residential’s downtown high-rise, sit vacant a year and a half after Meta announced it would sublease all of it. Meanwhile, Trammell Crow Company’s 601 West 2nd Street, formerly known as Block 185, is still unoccupied three years after topping out.
Meta and Google are on the hook for those lease payments even if they don’t move in, but widespread subleasing suggests there are limits to the need for Class A space.
In other words, Class A’s 65,000 square feet of net absorption is not the blowout win that some would have you believe.
Agarwal sees opportunity. Even as some employers cut or eliminate their office footprints, Texas remains one of the fastest-growing states in the country, drawing in white-collar professionals.
“The in-migration in Texas is so much greater than the loss of workers that it’s going to eventually overshadow it,” Agarwal said.
In Texas, where sprawl is the dominant mode of growth, four in five people who moved to the Austin metro area last year settled outside of Travis County, which covers downtown Austin and its immediate surroundings. Three of the four fastest-growing cities in the country last year were Austin satellites like Georgetown and Kyle, according to the Census Bureau.
Top law firms and Fortune 500 companies might draw these residents to glittering downtown towers. But thousands of dentists, accountants, administrators and paper-pushers anonymous are still going into the office, and will prefer places closer to their homes. Someone needs to rent the suburban space to their employers.
Price problems
Suburban Class B offices have taken a huge price cut. While pricing data is limited in Texas, the few deals with numbers available show just how far the prices have fallen.
“It’s the least hot — whatever metaphor you want to use for that,” said Steve Triolet, a research and market forecasting expert for Partners Real Estate.
Hartman’s Gateway Tower on LBJ Freeway is under contract for just $45 per square foot, according to data from Partners. Bradford Companies’ Bent Tree Green in Far North Dallas is under contract for just $61 per square foot.
Declining offices still have a floor value set by the desirability of Texas land. If a municipality will allow a developer to tear the office down and build something that better fits today’s market, like a data center or apartment building, then the property still has value as a development site.
“I was supposed to be in college, but I liked real estate better.”
“For some of the Class B or Class C product that is not functional anymore, is there an alternative use?” the thinking goes, according to Scot Farber of Younger Partners.
Alternatives are Capital Commercial’s mainstay.
The company’s first corporate campus deal centered on an old Iridium Communications satellite factory in Chandler, Arizona. Agarwal bought the 517,000-square-foot facility in 2009 for $18.5 million and put another $5 million into renovations. Capital Commercial lobbied to change the zoning on the property, which limited it to one tenant, and built out a new lobby.
The property had some quirks thanks to its Space Age past: triple 69 kilovolt-ampere feeds delivered enough power to the campus to keep a room chilled to 400 degrees below zero Fahrenheit, a necessity for Iridium to simulate the outer space environment of its satellites. Capital Commercial didn’t need a cold room. Instead, the company sold 323 acres of vacant land that drew from the power source to a data center developer.
After a 54-month hold, Capital Commercial sold the property for $63.9 million — nearly 3.5 times its purchase price.
Real estate reincarnation
In March, Capital Commercial bought 4200 Regent in Las Colinas from Property Income Advisors for just $56 per square foot.
The 164,400-square-foot office building dates from 2000 and is just 24 percent leased. That would normally be a complicated pitch for a lender, but Capital Commercial tells that type of story time and again.
Right now, the narrative hinges on pricing. Capital Commercial’s prizes might be old and out of style, but they exist.
While one of the biggest impacts of the pandemic on these aging offices has been on sale prices, the cost of new construction has also gone up. Not only are debt markets frozen, particularly for office space, but parts and labor are running well above pre-pandemic levels, too.
“A building that you could have built for $250 a square foot in 2018 or 2019 is now $425 a square foot,” Agarwal said.
The JCPenney campus was built in 1992 for around $350 a square foot, according to Agarwal. “Today, you couldn’t rebuild it for less than $800 per square foot,” he said.
At JCPenney, the investor added pickleball courts, a golf simulator, an arcade and cafes. The renovated Las Colinas space will accommodate eight to 10 tenants instead of one.
Capital Commercial spruces up amenities, modernizes interiors and improves dining options. The end result may not compete with the highest end of the market, but it comes in well below replacement cost.
“If the top guy is paying $85 per square foot, and you want to come rent JCPenney’s from me, I may be charging you $46 or $47,” Agarwal said. “You’ll be happy, because to rebuild that building, you’d have to pay $68 to $70.”
Agarwal’s ability to leverage someone else’s junk into his own treasure was evident early in his career, in a distressed deal that predates his foray into office. At 21, he scraped together $6,000 to buy a house out of foreclosure.
“I borrowed against the car I stole from my dad,” he jokes. “I was supposed to be in college, but I liked real estate better.”