Recently, a 1.8 million square foot building in New York City was purchased for $600 million. That may not seem newsworthy except that the asking price prior to the sale was $1.74 billion. The drop in price could be attributed to a variety of factors, one of which may be that of the 1.6 million square feet available for rent, only half was actually occupied.

A sale price of 65% of the original cost is enough to draw the attention of even the most cautious of investors, but those who are both careful and keen know that there is more to a good investment than a low price. A decrease of this magnitude in the span of two and a half years is an indication that something is amiss.

The New York City rental market is no different than other real estate market sectors. Vacancies are high and rents are declining. The subject property is 50% vacant. Given that fact, it is reasonable to presume that the property is generating an operating negative cash flow. Even if the property were bought for all cash, when you add back concessions, the property would be generating an operating negative cash flow. By any logical standard, any operating business with a negative cash flow is a failing business. In other words, the buyer spent $600 million for a failing office building business.

The overarching question is: What do the new owners need to do to convert their failing office building business into a successful one? The obvious goal is to increase the percentage of leased space from 50% to 95%. Not impossible, but very difficult. Following are some realistic scenarios. Increasing occupancy in 10% increments per annum means it will take five years to get there. To accomplish this, the buyer needs to be prepared to spend a significant amount of capital. These costs will include tenant improvements (TIs), leasing commission, and negative cash flow.

New lessees never say the space is perfect. In weaker markets, lessees are more demanding and the lessor pays. To get to 95% physical occupancy, 360,000 square feet need to be leased. The going rate for TIs is in the area of $125 per square foot. That comes to approximately $45 million.

Not only do costs attributed to remodels and maintenance take a financial toll, but there are also certain fees and commissions associated with rental space. Agents charge fees of 5% to 6% of the lease amount to locate renters for the property. This fee must be paid up front. So at a 5% commission rate, the investor will pay about $3 million on a three-year lease at $50 per square foot.

With expenses reaching into the millions, it is unlikely that this property will turn a profit if the buyer has not set aside enough to cover these costs. But planning and persistence could pay off if the economic climate stabilizes. In a span of five years, with a capitalization rate of six percent, the investment could increase to $750 million. Of course, this transaction is not a loss for all involved. For the recipient of fees, commissions, and oversight, the investment may be a profitable. The point is an investor must always be wise about a great deal that is presented. It is important to investigate all the facts before making such a large investment.