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