At the Office Crossroads
What’s the next move for investors?
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
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?
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
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
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.”
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