Office

Chasing Yield

Office investors take on more risk as they move into noncore markets.

As competition for core properties continues to intensify, office investors have been casting a wider net to move capital off the sidelines and to capture higher returns. The question is, How much risk are buyers willing to assume when the office recovery still has a significant hill to climb?

Office sales are on the rise in cities ranging from Portland, Ore., to Pensacola, Fla. — clear evidence that investors are gaining confidence that office values have stabilized and are poised for a rebound.

“Over the last year or so, we have started to see investors come back into the market,” says Russell Webb, CCIM, a managing partner at Silver Oak Commercial Realty in Southlake, Texas. Last year in particular, Webb saw an uptick in his niche: all-cash buyers looking for 1031 properties in the Dallas-Fort Worth metro, including those from California and the East Coast. The pending changes to capital gains tax laws sparked a flurry of sales transactions during fourth-quarter 2012. Silver Oak sold 12 buildings last year by December 31. And Webb is optimistic as buyers have remained in his market.

Nationally, office sales totaled nearly $80 billion in 2012, which is a 23 percent increase over the prior year, according to New York-based Real Capital Analytics. Even after a surge of buying boosted 4Q12 sales alone to $31 billion, 1Q13 posted a respectable $16 billion in sales, which is a slight 2 percent gain compared with 1Q12, according to RCA.

Confidence Grows

Signs that the office market has turned the corner are giving buyers added confidence in taking on more risk in what continues to be a highly competitive market for top-quality office properties. Office tenants continue to chip away at the excess supply of available space. During 2012, the national office vacancy rate declined a slight 30 basis points to reach 17.1 percent at the end of the year, according to Reis. That trend has continued with a further 10 bps drop during 1Q13 to reach 17.0 percent.

Extremely limited new construction is more good news for office investors. Only 1.7 million square feet of new office space came online during 1Q13, according to Reis, which is the lowest recorded quarterly total for new completions since 1999. In fact, 2013 construction activity could rival the record-low building level of 7 million sf set in 1994 in the wake of the savings and loan crisis.

Yet the office investment market remains divided into two camps. On one side are those investors focused on core assets in top markets with stabilized occupancies at 85 percent or above. The other side consists of value-add buyers that are willing to take on a property with 30 to 70 percent occupancy. Although they follow vastly different strategies, the two groups both have a strong appetite for office properties and a desire to achieve higher yields for the risk they are assuming.

Given the fact that the office recovery in many metros still has a long road to travel, investors continue to gravitate toward the relative safety of core office properties. “There still is a flight to quality,” says Casey Keitchen, CCIM, a vice president in the national office group at Bull Realty in Atlanta. “Investors want the best quality and the best location in the best submarket.”

However, it is becoming harder for some buyers to compete for well-located, well-leased class A office properties in the top 10 U.S. metros. “Investors are getting pushed out of those markets, because there is so much competition,” Keitchen says. Those buyers are turning their attention toward class A properties in secondary markets and top suburban markets, as well as to class B+ and B properties in major metros. “We are definitely seeing investors willingly go up the risk spectrum in search of yield,” he adds.

The Value-Add Play

Buyers shopping for higher returns are finding them in the Detroit metro area. “Lately, we are a magnet for out-of-town, value-add investors looking to buy underperforming assets at a fraction of replacement cost,” says Larry Emmons, CCIM, SIOR, senior managing director at Newmark Grubb Knight Frank in Southfield, Mich. Buyers are looking for class A and B multitenant, multistory buildings in prime suburban markets — namely Southfield and Troy — as well as in Detroit’s central business district.

Tenancy throughout the Detroit metro really fell off during the recession as the big auto firms struggled and auto suppliers were forced to cut back. In a number of office buildings, occupancies dropped from 80 percent to as low as 30 to 35 percent. Once occupancies start coming back to more than 50 percent, people start to take notice, Emmons notes. “You couple that with the fact that most of these buildings have been able to be purchased way below replacement cost, and that is another good barometer for out-of-town investors,” he says. NGKF recently brokered the sale of the Travelers Tower I and II buildings in Southfield. The two class A buildings, which combined total 790,000 sf, were listed after Thanksgiving last year. The property quickly attracted nine written offers within a three-week period with the highest bid exceeding pricing expectations by nearly $2 million. The three highest offers were all from out-of-town buyers in New York and Chicago.

Tertiary Market Hurdles

Given the investment opportunities that still exist in large secondary markets and top suburban markets, national buyers have been slow to trickle down to tertiary markets. At some point, institutional investors will eventually turn to the tertiary markets. The tipping point will come when pricing becomes too high or the available product on the market is not meeting demand. However, that shift could still be at least a year or two away for many markets.

For example, investors are slow to move back into markets such as Omaha, Neb., which has an office market that spans about 20.5 million sf. “When we had our last period of very, very white hot real estate market in 2006 and early 2007, we didn’t see the national buyers come to the Omaha market until the very end of that trend,” says Ember Grummons, CCIM, an investment broker at Investors Realty in Omaha.

However, brokers such as Grummons are beginning to field calls from interested office investors. “I think that trend is coming, but it is the very leading edge,” he says. Those office properties that are trading in tertiary markets are largely occurring among small, owner-occupied buildings. Local buyers also are finding opportunities on “broken deals” and properties that have high occupancies, need repairs or maintenance, or have been mismanaged, he adds.

For example, Grummons recently represented a local buyer in the acquisition of a 136,000-sf class B- suburban office building in Omaha. Although the building is 93 percent occupied, the buyer is assuming unfavorable financing with an existing above-market rate conduit loan. The prepayment penalty was extremely high, making it economically unfeasible to prepay the loan. The buyer will have to carry the current loan for another five years, and then refinance in a market where interest rates most likely will be higher than they are today. “We’re getting paid for that risk with a higher than market cap rate,” says Grummons. The property closed in May at an 11 percent cap rate.

Activity Pockets Persist

Drilling down to smaller markets, there is both activity and interest that varies on a case-by-case basis. “We have seen a steady, slow increase in activity of office investment sales over the past year,” says Justin A. Beck,CCIM, CPM, president of the Beck Property Co. in Pensacola,Fla. What is drawing outside investors to smaller markets such as Pensacola is that the area has a good story to tell, he adds. For example, Navy Federal Credit Union announced in April that it is planning a $200 million expansion at its Beulah campus that will add 1,500 new jobs by the end of 2015 and potentially an additional 4,700 jobs by 2020.

“We think that there are some really nice pockets of activity and growth in this region, and that’s where the majority of these sales have taken place,” Beck says. That economic activity has piqued the interest of private investors, mainly high-net-worth investors or small private funds, from southern Florida as well as California and the northeastern U.S. For the most part, those outside investors are pursuing stable properties and are getting at least 50 to 100 basis points — even 150 basis points more — by going into a smaller market like Pensacola, Beck notes. At the same time, buyers are looking for easy-to-manage properties, mainly buildings with larger and fewer tenants.

Local buyers are primarily focusing on value-add opportunities. In the Pensacola region, there is not a tremendous amount of vacancy. So with a building that has some vacancy, “buyers have a pretty easy path in front of them, because the lease-up is not that difficult,” Beck says.

Buyers also are finding opportunities with properties that have leases coming due. During the recession, landlords made some very aggressive deals to fill vacancies. “Now those leases are coming up, so there is opportunity for the value-add investor to go in and renew and get a little more of a market rate renewal,” he says.

For example, Beck represented a buyer late last year on a $2 million purchase of a 28,000-sf office property in Pensacola. The building was 100 percent occupied, but sold at an 11 percent cap rate, in part because the property had several lease renewals coming up. By improving management and renewing leases at higher rents, the owner expects to increase cash flow by 20 percent within the first year, Beck notes.

There are a lot of quality properties in tertiary markets that have strong local economies, Grummons agrees. Cities such as Omaha; Des Moines, Iowa; Tulsa, Okla.; and Wichita, Kan., all have metros with populations of more than a half-million people and solid economies where unemployment is below the national average. “But, there just aren’t bidders for these properties, and that is stunning to me, because they are good properties and good markets,” he adds.

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

Beth Mattson-Teig

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

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