Office CCIM Feature

Upping The Ante

Investors expand their foothold in office secondary markets and suburbs in the search for higher ROI.

Investors have plenty of capital to spend and a desire to grow office portfolios - and more of that capital is moving away from major metros. The economic recovery that has been slower to trickle down into secondary and tertiary markets is gaining traction, and investors clearly are taking note of that market shift.

As a result, investors have started shifting to secondary markets, such as Las Vegas, because the gateway markets really have topped out for market pricing and property values, notes Soozi Jones Walker, CCIM, SIOR, president and broker at Commercial Executives Real Estate Services in Las Vegas.

“Bigger institutional investors are coming to our market to look for higher yields,” she says.

The Las Vegas metro was hard hit by the Great Recession, but investors now recognize that property values have bottomed out and have started to rise. In Las Vegas, office vacancies have dropped to about 13 percent and are still improving, along with an increasingly diverse economy, Jones Walker notes. Investors seem to have “pots of money” even for Class B assets in secondary markets, she adds.

Better Yields

Cap rates in the gateway markets have dropped below 6 percent, which makes it very difficult to build in enough income growth or underwrite at a low enough exit cap rate to achieve the double-digit IRRs that investors expect to see, says Gary Lyons, CCIM, SIOR, senior vice president, Investment Sales Team at Avison Young in Raleigh, N.C.

“They are naturally migrating to secondary markets,” he says. During the first three quarters of 2017, office sales in major metros reached nearly $50 million, which was down 16.5 percent compared to the same period a year ago, according to Real Capital Analytics. In comparison, sales transactions in secondary markets increased 8.3 percent to $38.6 billion.

Investors have taken notice of the strong fundamentals in Raleigh-Durham, N.C. The metro is continuing its solid recovery, with annual absorption that surpassed 800,000 square feet in 2017, and office rents that are rising at a rate of 5 to 6 percent in both Class A and Class B sectors.

“The amount of institutional capital in our market is higher than it has ever been,” Lyons says. “There are a lot of big players and big money looking for deals here.” Sales for the first three quarters of the year totaled nearly $700 million, which is up 14 percent year-over-year, according to Avison Young.

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National data points to an office market that is  stable - and perhaps a bit stagnant. Construction and absorption both have been moving forward modestly, which has been producing a net neutral effect on occupancy levels.

U.S. vacancies have remained flat during the past two years at an elevated rate of about 16 percent, according to Reis. Yet the tide is not lifting all boats the same, and investors are taking a deeper dive into secondary and tertiary markets.

Changing Markets

For example, Omaha, Neb., is experiencing an uptick in sales activity that is coming from local as well as regional and national investors. The metro had  several properties traded in 2016 and 2017 for cap rates  at 10 percent.

“Those are very, very high capitalization rates for good product,” says Ember Grummons, CCIM, an investment sales broker at Investors Realty in Omaha. Cap rates have since dropped below 10 percent, but they are still high compared to other markets. Those yields are attracting more investors to the market, he adds.

Buyer attention also is expanding to include best-in-class suburban assets. “Single-tenant office has been hot all along,” Grummons says. “But suburban multitenant office has been out of favor for a long time, and I feel like it is starting to come back.” 

Nationally, 2017 office investment sales through November topped $126.9 billion, which is down 11 percent year-over-year. More telling is that suburban office sales remained relatively flat at $71.1 billion, while CBD sales dropped 25.2 percent to $41.6 billion.

Class B properties also are becoming more attractive to investors, as vacancies start to shrink and rents start to rise. In Omaha, the Class B sector was hurt by the flight to quality that occurred several years ago.

Vacancies have since improved to 10.6 percent, and Class B buildings are beginning to fill up again. Rents for Class B have been flat for some time, while the cost for tenant improvements has gone ballistic.

That has lowered returns for owners and made Class B office investments less attractive for buyers, according to Grummons. “We are just starting to see a little creep up in Class B rents, and, personally, I think that will accelerate,” he says.

Revitalizing Smaller Cities

Even tertiary markets are getting a lift from a stronger economy. Columbus, Ga., has seen a return of positive leasing and expansion during the past two years. Much of that activity is focused squarely on the city's downtown, due to ongoing revitalization and new investment that has occurred over the past 12 years.

For example, the city has worked to create a hub of activity ranging from a thriving restaurant scene to outdoor recreation, with a new man-made white water course that opened on the Chattahoochee River in 2012. “Our downtown is really a model downtown that you will hear a lot about in the future,” says Leah P. Braxton, CCIM, vice president, Brokerage Services at W.C. Bradley Co. Real Estate LLC in Columbus.

Recent redevelopment projects for W.C. Bradley include Eagle & Phenix Mills, a mixed-use historic redevelopment along the river that has created condos, apartments, office space, and ground-floor retail and restaurant space. Last year, the company also announced plans for The Rapids at Riverfront Place, a $52 million development that will include apartments, retail, and restaurants. The growing residential and retail space also is beginning to attract more office users that are relocating from the suburbs, Braxton notes.

Seller's Market

The biggest challenge in secondary and tertiary markets is finding deals at scale. Most institutional buyers want to write $30 million to $40 million equity checks, which translates to an $80 million to $100 million deal, and there just aren't that many deals of that size in smaller markets such as Raleigh-Durham.

“That is probably one of the most frustrating aspects of this market for institutional buyers,” Lyons says.

Another challenge is that some owners are reluctant to sell in a market where it is more difficult to find replacement assets. “We have the tale of two worlds here in our market in southern Nevada,” Jones Walker says.

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On one side, the REITs are looking for properties to buy in Las Vegas, and the handful of institutional assets in the market have been trading at lower and lower cap rates. “From an investment-grade standpoint, we are on everybody's radar as they march across the country looking at areas such as Phoenix and Salt Lake City,” Jones Walker says. “But there is a constraint of that type of product here. The velocity is not there.”

The flip side of the office investment market in Las Vegas is one dominated by smaller buildings and local tenants that smaller investment groups pursue. There is much more activity on subinvestment-grade office properties.

“We have a lot of Class B here, because the land is more affordable,” Jones Walker says. Those buyers are looking for a little higher cap rates, but sellers are in a quandary because they don't know what the tax consequences might be in the wake of tax reform, and they don't know where they would put that money, she adds.

Niche Office Markets

Buyers continue to fuel a very hot sales market for small office and medical office buildings priced under $3 million, according to Ross Hedlund, CCIM, senior vice president of corporate services at Frauenshuh  Commercial Real Estate Group in Minneapolis.  “We have been seeing a ton of investors, even first-time investors in real estate, who are buying up smaller Class B and Class C office buildings and smaller medical and dental buildings.” 

People have done well with other investments and have capital to spend. At the same time, some are worried about high values in the stock market and are looking for other places to put their capital, he adds.

In Minneapolis, rents have been rising, with increases in the past year of about 3 percent. “I think that is helping to drive values up too,” Hedlund says. “When people are underwriting with future cash flows and cap rates, they are able to pencil out a better purchase price.” 

Even some of the properties that traded a few years ago are re-trading, maybe at the same cap rate, but with higher in-place income and higher values, he says.

Generally, a lot of capital continues to be available for office properties both on the equity and debt side. “Lenders are still being extremely aggressive to place their capital, and a lot of the equity guys are anxious to place their capital,” Hedlund says. “At the moment, it definitely seems that the future is still bright for continuing to have strong sales volume and potentially sale prices that are inching up.”


Facts about Office

  • The balance between density and collaborative space has become increasingly significant for workplace design.
  • The fast-growing technology industry often seeks office space in secondary markets, boosting its expansion.
  • The cost per workstation in the U.S. jumped by 4.2 percent in 2017.
  • As user experience gains relevance in the workplace, more offices will be designed to make each member of staff more comfortable, happy, and productive.

Source: Cushman & Wakefield

Smart Building Technology Emerges

by Beth Mattson-Teig

Consumers are creating a smart home experience with gadgets, which allow them to do tasks ranging from turning off  appliances and lights to activating security cameras and door alarms — all from their smart phones. Office workers now can use those same technologies to create a more comfortable workplace.

“You see a lot of technological innovation happening in homes and other areas of our lives, and we’re bringing those technologies into the workplace,” says Lindsay Baker, president at Comfy, a software company that provides workplace tech solutions for large occupiers, including the likes of WeWork, Intel, and Cisco.

Commercial smart building technology has been focused on creating efficiencies behind the scenes with automated systems that control everything from lighting to elevators. Now, more of that tech is being pushed to the forefront with tools that can enhance the experience for tenants and their employees.

For example, five years ago Comfy first launched an app that helps occupants in large buildings manage the temperature in the workplace more effectively.  Now, the company is expanding its product offering to help control lighting, book rooms or desks, and navigate around large corporate campuses.

Technology allows people to customize their own space, such as changing the lighting from cooler tones to warmer tones. Other examples of new tech tools include electrochromic windows that create changeable glazing that allows  occupants to adjust the light transmittance or transparency of windows.

The increased automation in buildings makes people feel like they have a lack of control, Baker notes. For example, people no longer have the option to open a window or even turn down a thermostat when they are too hot.

The emerging new technology enhances the workplace and gives some of that control back to workers. “Everybody is talking about wanting to improve the employee experience, and one of the ways to do that is by empowering people,” she says.

Employers are recognizing that technology apps aimed at improving the workplace experience can help improve engagement with workers and potentially improve employee retention and productivity. At the same time, landlords are recognizing that workplace apps create an added amenity that can help to attract and retain tenants.

The big fallacy about automation in buildings is that it assumes that everyone wants the same thing all the time, and that is simply not true, according to Baker. Some people thrive on being able to look out a window and enjoy the view, while to others that same view might be a distraction. Being able to change that view easily with a simple app gives occupants more control over their environment and allows people to personalize space to suit their own preferences.

“During the past couple of years, landlords and corporate real estate teams are realizing that they need to take a more active role in introducing new workplace technologies, and they also are putting that tech directly in the hands  of office workers,” Baker says. “Occupants are demanding more control over the physical infrastructure of their workplaces, preferably from their smartphones and personal devices. Forward-thinking building owners are recognizing  and meeting that challenge.”

 

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Beth Mattson-Teig

Beth Mattson-Teig is a freelance business writer based in Minneapolis. 

 

 

CIRE March/April 2018 Issue Cover

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