Office

At the Office Crossroads

What’s the next move for investors?

By Rich Rosfelder |

The office investment market is at a crossroads. The spread in capitalization rates between office properties in core markets vs. office properties in secondary and tertiary markets reached a 10-year high in first quarter 2012, according to Real Capital Analytics. “This has to change,” says Dan Fasulo, managing director of RCA. “Either major metro cap rates will start to rise, or secondary and tertiary market cap rates will fall. Investors are betting on the latter.”

Secondary and tertiary market office cap rates began to close the gap last year, dropping from 7.9 percent to 7.8 percent and from 8.5 percent to 7.8 percent, respectively, according to RCA. This reflects an uptick in interest among investors, who purchased more than $19.5 billion in office assets in secondary markets in 2011. And with more than $5.6 billion in office sales in 1Q12, secondary markets are clearly gaining momentum.

But while year-over-year increases in secondary market office sales averaged 25 percent in 4Q11 and 1Q12, tertiary markets showed negative growth overall. Are office investors poised to enter these markets or are they biding their time?

Small-Town Logic

“It seems logical that investors would expand to tertiary markets, if they are willing to take on more risk,” says Kenneth P. Riggs, CCIM, CRE, MAI, chief real estate economist for CCIM Institute and president of Real Estate Research Corp. in Chicago. “In secondary and tertiary markets, there are better risk-adjusted returns, and better pricing and opportunities, including diversification and geography.”

In some parts of the country, the expansion has already begun. Tertiary markets in the Mid-Atlantic, Northeast, Southeast, and West all saw year-over-year increases in office transaction volume in 1Q12, according to RCA.

This uptick might have been more significant if not for the prevailing perception among investors that small markets are hamstrung by stagnant economic growth. But a closer look at recent employment numbers reveals a different story. The Bureau of Labor Statistics reported that 246 of 372 metro areas experienced year-over-year increases in nonfarm payroll employment in April. In addition, 214 cities had unemployment rates below the U.S. average of 7.7 percent. This bodes well for office fundamentals in tertiary markets.

And in an effort to change investors’ perceptions, CCIMs based in these markets are spreading the good news. For example, Linda Gibbs, CCIM, SIOR, and Timothy J. Sharpe, CCIM, SIOR, senior vice presidents with CBRE/Hubbell Commercial in West Des Moines, Iowa, discussed their market’s 5.6 percent unemployment rate and strong financial sector in an article they wrote for the April edition of Heartland Real Estate Business. They point out that the national average for suburban office cap rates is 7.6 percent, but Midwest tertiary markets average 8.1 percent. “The long-term outlook is positive,” Sharpe says. “Cap rates on the West Coast are 200 basis points lower than here. We’ll see the overflow in the next 24 months.”

But other factors are complicating the positive outlook for tertiary markets. In Omaha, Neb., “Some sellers are still in the process of re-tenanting their office properties from the recent downturn and are reluctant to sell with depressed net operating incomes unless they are forced to,” says Ember W. Grummons, CCIM, of Investors Realty in Omaha. “Nothing has traded over $4 million in the past 18 months.”

Tenants that have downsized are now looking for smaller, more-versatile spaces, and buyers are following suit. Josh Cunningham, of Surterre Property in San Clemente, Calif., notes that traditional 3,500-square-foot to 20,000-sf office properties in his market are being passed over in favor of 1,500-sf to 3,500-sf properties that include warehouse or showroom space. “Many owners are offering improvements or carry-backs just to get an offer on the table,” Cunningham adds.

Next Big Things

Such concessions aren’t necessary in secondary markets with strong technology and energy sectors, where investors are now competing for top office assets. For example, CommonWealth Partners recently purchased the 872,026-sf Russell Investments Center in Seattle for $480 million. “There were 34 prospective buyer tours of the asset, which is highly unusual for a deal of this size and demonstrates the tremendous amount of capital that exists for core CBD assets,” says CBRE Vice Chairman Kevin Shannon, who led the sales team representing the seller, Northwestern Mutual. “This is especially true in rising markets, like Seattle, that are experiencing strong job growth resulting in aggressive rent growth.” The Russell Investments Center transaction was the largest single-asset office sale on the West Coast since 2006.

Austin, Texas, is also a prime target for investors. In February, private equity firm Pearlmark Real Estate Partners purchased a four-building office portfolio totaling 292,398 sf from The Blackstone Group for approximately $42 million or $147 psf, according to CoStar. RCA reports that Austin’s suburban office properties traded at an average of $182 psf in 1Q12, the second-highest psf price for suburban office assets in the Southwest region.

“High tech is booming in Austin, and medical office is very much in demand,” says Bob Rein, CCIM, associate vice president with NAI REOC in Austin. The city is expected to add 27,000 new jobs this year, mostly in education and healthcare services. And Apple recently announced plans for a $304 million Austin campus that will create more than 3,600 new jobs.

All of this positive activity is driving down cap rates in top secondary markets such as Austin and Seattle. Investors looking for higher returns are beginning to venture farther afield. “We are seeing good office investment opportunities in Richmond, Va., Baltimore, Pittsburgh, Nashville, Tenn., Charlotte, N.C., Portland, Ore., and Raleigh, N.C.,” Riggs says.

Gary Lyons, CCIM, SIOR, vice president with Lincoln Harris in Raleigh, calls Archon Group’s recent $43.9 million purchase of a 427,160-sf office portfolio a “turning point” for the Triangle region. “Their investment demonstrated that a large, national player was willing to make a major commitment to our market,” he explains. “The transaction set a price floor of around $103 psf for moderately or well-leased class A-/B+ buildings in a mix of locations.”

Life insurance companies are financing most of the large office deals in his market, Lyons says, while regional and national banks are handling smaller transactions. Loan-to-value ratios typically range from 62 percent to 78 percent. “Our community and regional banks seem to be getting healthier and are becoming very bullish on owner-occupied real estate,” he adds.

Other secondary markets are struggling with some of the product limitations also affecting tertiary cities. In Southwest Florida, “Some of the higher-class multitenant office buildings offer a higher square-footage-per-employee layout than what is typically being searched for today,” says Adam Palmer, CCIM, managing director of LandQwest Commercial’s office division in Fort Myers, Fla. “Savvy investors are adding retrofit costs to reflect this in their basis prior to calculating their purchase offers.”

Despite such obstacles, Palmer argues, now is the time to buy: “I am confident that a handful of the sales taking place today will statistically prove to be more affordable and advantageous than the averages we will see in the future.”

Wild Cards

The best institutional-grade office assets with credit tenants in secondary markets will continue to be sought by pension funds, foreign investors, REITs, and insurance companies, Fasulo of RCA says. But he also points out that secondary market cap rates leveled off in recent quarters as investors began to pursue lower-quality, value-add assets.

For example, last year Trammell Crow Co. and Principal Real Estate Investors purchased a vacant two-building corporate office complex in suburban Houston with plans to reposition and pursue Energy Star and Leadership in Energy and Environmental Design certifications, according to CoStar. In January, Noble Energy leased the entire space.

R.C. Myles, CCIM, SIOR, senior vice president with Cassidy Turley Fuller Real Estate in Denver, is seeing more demand for suburban distressed product in his region. Orchard Centre, a 120,000-sf real estate-owned office property in Greenwood Village, Colo., was vacant when Myles’ team secured the listing. Without a formal marketing campaign, the property soon attracted more than 25 investors for tours and generated interest among potential tenants.

In addition, “Returns on class B and C properties, which are trading at cap rates from 8.2 to 9.5, are easily 200 bps higher than class A properties,” Myles adds. “When you can borrow at 4.5 percent and buy at an 8.2 cap rate, that’s a great opportunity.” There were 33 class B office transactions totaling nearly $300 million in Denver last year, as well as nine class C totaling more than $23 million, according to a Cassidy Turley Fuller Real Estate report.

But if such activity is to increase in noncore markets, one investor segment needs to return, Fasulo says. “Private investors have been left out of the party because they still have difficulty getting access to capital since the loss of commercial mortgage-backed securities,” he explains. “A CMBS comeback is the wild card for growth in secondary and tertiary markets.”

CMBS issuance was expected to reach $20 billion by midyear, up nearly $3 billion from last year’s first half, according to Commercial Mortgage Alert. The sector is on track to exceed the $38 billion annual issuance forecast, which is good news for private investors and smaller office markets.

But CMBS isn’t the only wild card, Fasulo says. Europe’s financial problems, congressional stalemates, and the upcoming presidential election could all affect the prospects for increased office investment. “The current climate is causing investors to pause, which is never good in our business,” Fasulo adds.

In the case of most secondary and tertiary cities, investors may be waiting, in part, for fundamentals to stabilize or improve. “While there are good opportunities in some areas, many of these markets have office vacancy rates higher than the national average or higher than historic averages, with little expectation of additional demand from job growth to fill the space or to grow rents,” Riggs says.

But that’s not to say that an office sector recovery in these cities is a distant dream. “Assuming there are no unexpected shocks to the national economy, I expect to see office investment activity pick up in our market in the next 12 to 24 months,” Grummons says.

After a difficult few years, most brokers in small markets are prepared for the worst. But the next “unexpected shock” could be an influx of investors.

Rich Rosfelder is associate editor of Commercial Investment Real Estate.