We have been waiting to give you a status report on the project, because we had hoped to announce our first new lease, confirming the project concept and the market. Because that has not yet happened, we will give you a more detailed analysis of where we are and what our plans are going forward. We are going to share confidential details, and know that you will guard them as such.
We closed escrow on November 9, 2012 and began construction on December 26, 2012. We decided to do the renovation in two phases, because we wanted to be careful not to overbuild for the market. The first phase included reroofing the building with a new metal standing seam roof and canopies on the four corners of the building, installing the operable windows, relandscaping the front 20’ of the project as well as the two main entrances to the building, renovating the lobby area into a common gathering space with an honor coffee bar and free water/ice dispenser and relandscaping and furnishing the two atrium areas into casual sitting/gathering spaces. We also remodeled a 2,500 sq. ft. “spec suite” so we could show prospective tenants and brokers the benefits of creative office space: abundant natural light, high ceilings, polished concrete floors, attractive kitchen area, etc. Attached is our leasing brochure which shows photos of the spec suite.
We have been actively marketing the project since before we closed escrow. Our leasing brokers are Michael Slater and Tom Dwyer from CBRE, two of the most respected and experienced brokers in the marketplace. Upon completion of the renovation and spec suite in April, we hosted a Broker Open House that was attended by about 50 brokers from the area. All of the feedback we have received has been extremely positive. They believe the building has a “new life” and like the features and amenities we have provided.
We have had proposals to lease from five tenants, and have had leases in negotiation with two of them. Very early on, we had a lease in negotiation with an entrepreneur for about 4,000 square feet but his business had a downturn and he decided to stay in his existing small space for at least another year. Last week, we had a lease ready for signature with a 9,500 square foot co-working company (a modern “executive suite” concept), which would have been an excellent tenant for the project. They would have started with the spec suite, then expanded over the next six months into adjacent suites. The day we were set to start on our TI plans, they informed us that they decided to open an office in New York first, and put our project on hold, likely for six months or longer. We believe a co-working company would be a great tenant for our project and we are actively approaching companies with offices in other parts of LA to expand to Westlake Village. The lease rates with these two tenants (respectively) were $2.12 and $2.15 per square foot, modified gross, with free parking. This is about 6.5% below our pro-forma rate including parking for 2014, but still would have provided a decent return on our investment.
We continue to have four or five solid lease prospects for our creative office space. Our best prospect is Cal Lutheran University, who is looking for 15,000 square feet in Westlake Village near a freeway for their Graduate School of Management. Fifty percent of the space would be classrooms for their nighttime executive classes, and 50% would be incubator space for new small businesses, where they would provide management support. They have toured the building three times, including with the President of the University, the Chairman of the Board, the Dean of the School of Management, etc. Our project fits their strategic plan very well. They are currently doing layouts to determine what the scope of tenant improvements would be. Due to the size and internal approvals required, it will likely take four to six months before we would have a signed lease, and the lease would likely not start until April or May of next year.
We have several other tenants (mostly tech-related) who we are touring and tracking, but no one is ready to make a commitment. The summertime is traditionally a very quiet time for leasing, and we would not expect activity to pick up until September. Our biggest hurtle is selling the fact that by having more flexible, open office space, tenants can reduce the amount of space they need and save significant dollars. We have tried demonstrating this to them, but it has been a very difficult sell and we are unsure why. Tenants seem to get fixated on a square footage size, and it is hard for them to understand how they can make do with less.
In the meantime, we are working hard to keep our existing tenants happy and paying their rent. The renovation was much more disruptive than we anticipated, but we worked closely with them and they were extremely understanding. We hosted a Tenant Appreciation Lunch when the renovation was complete, and they were enthusiastic about the improved building. We have renewed Diodes for one year (850 sq. ft.), are negotiating a 507 sq. ft. expansion with Heywood Friedman, and expect Call Source (5,348 sq. ft.) to extend for one year when their lease expires in September. All of these renewals/expansions are 3% increases over their existing rents, so in the $1.85 to $2.25 psf full service gross range. We thought it was better to keep the existing income (with no TIs) than try to push them to a higher rate and possibly lose them. The other tenants whose leases expired did move, as we expected. We also had a tenant default on their lease, Dynamics Perspective. They have moved out and stopped paying rent in March. We have a judgment against them and are pursuing collections, although we expect to receive a fraction of what they owe us (likely $15,000 to $30,000).
The good news is that the market is strengthening. The vacancy rate in Westlake Village has dropped to about 15%, and rental rates are stabilizing. Thousand Oaks (to the west) has a significantly higher vacancy rate of 26% and while we do not directly compete with any of those buildings, it is a “low cost alternative” which is keeping downward pressure on the rental rates in the area. The buildings that are doing leases are either Class A buildings geared toward financial companies or Class B- buildings who are doing cheap leases. Many tenants are electing to renew for a short (1-2 year) term, as they see where their businesses are headed. They are reluctant to spend the funds to move and commit for a longer term. We have had several sizeable tenant leads who have made this choice (Alta Sens, Call Source, Golden Eagle).
Financially, the project is in pretty good shape. The construction costs for the first phase of renovation and the spec suite were slightly higher than we anticipated, but covered by our contingency. We have spent a total of about $10 million on the building so far: $8.4 million for the building and $1.6 million in renovation and soft costs (see Budget vs. Actual analysis attached). We are managing the project as efficiently as we can, which is keeping our operating expenses at a reasonable level. At this point, our net cash flow after paying all debt service is about at break-even, excluding the $43,000 property tax bill we have to pay in December.
So, where do we go from here?
We are working closely with Michael and Tom to tweak our marketing strategy, including offering broker incentives. We are continuing to cold-call tenants in the area, send out our video on the project and network with brokers. We are also contacting co-working companies to see if there are any which would expand to the Westlake Village area, as well as incubators and accelerators to see if they have companies looking for more permanent space.
We are considering marketing the building on a two-tiered basis, based on their tenant improvement needs. We are continuing to market it as creative office space, but have lowered our asking rate to $2.20 per square foot, modified gross. We also have realized that tenants will not pay for parking (uncovered or covered) at this time. Attached is an annualized projection showing the pro-forma rents based on a reduced rate for creative office space. As you can see, the investors would receive an annual cash-on-cash return at stabilization of approximately 9.1%. If then we were we were to sell the building at a 7% cap rate, the investors would receive a 20.9% return on their investment.
We are also marketing the project as a modern, updated building with more basic tenant improvements. We can save significant tenant improvement funds if we do not have to reconfigure the HVAC system, separately meter the electricity, demo the dropped ceilings and polish the concrete floors. In this case, we would lease the space at $2.10-$2.15 full service gross. This seems to be a slightly aggressive rate compared with Class B office buildings, but we think it is “doable” given the newer quality and feel of our building.
Attached is an annualized projection showing the income based on this traditional office scenario. Our total costs would be approximately $13.2 million (vs. $14.2 million originally budgeted). As you can see, the investors would receive an annual cash-on-cash return at stabilization of approximately 8.4%. If then we were to sell the building at a 7% cap rate, the investors would receive an 11.5% return on their investment.
We should have a much better indication of where we are at the end of September. If we have good news before then, we will certainly share it with you. In the meantime, we are managing the project as prudently as possible. To date, Creative Office Properties has not taken any project management fees. We will only do so once we have shown that the project is leasing such that it is achieving positive returns.
Please let me know if you have any questions.
LC3 Projected Income Creative Office Lower Rents 6 28 13
LC3 Projected Income Traditional Office 6 28 13
