Office: Risk vs. Reward

As capitalization rates continue to compress for core office assets, one red flag being raised is whether investors are biting off more risk than they can chew.

Clearly, office buyers are willing to take on more risk as long as they are paid for that strategy with higher yields. Time will tell whether buyers are becoming overly aggressive in their underwriting assumptions. Most investors are anticipating growth in occupancies and rental income, but not necessarily expecting big rent growth, particularly given the significant competition that remains in the market to fill space among class B and C office buildings, notes Larry Emmons, CCIM, SIOR, senior managing director at Newmark Grubb Knight Frank in Southfield, Mich.

That is most likely a prudent move as effective rents remain relatively flat. On a positive note, asking and effective rates have now risen, albeit slightly, for the past 10 consecutive quarters. Asking and effective rents both grew by 0.7 percent during first-quarter 2013, according to Reis. That being said, national effective rents are still about 7.7 percent below peak levels that were observed during 2Q08.

When underwriting stabilized assets, buyers are looking beyond the surface of a national credit tenant. “You have to dig a little deeper in these smaller markets, because you have to look at what these tenants are doing nationally,” says Justin A. Beck,CCIM, CPM, president of the Beck Property Pensacola,Fla. Just because a national company has a presence in a smaller secondary or tertiary market is no guarantee that the tenant will remain. Some national firms have downsized considerably, closing and relocating some offices all together. “Those are important things to look at. It can’t simply be a national credit in a local market,” he adds.

Value-add investors are still wary of taking on too much risk. With an underperforming property, positive cash flow at closing is critical.“Very few buyers take interest in a negative cash flow asset,” notes Emmons. Buyers also are scrutinizing capital expenditures, such as deferred maintenance on roofs and HVAC systems, as well as gauging leasing velocity in the local market or submarket.

Those buildings that have negative cash flow due to low occupancy or other maintenance issues continue to languish on the market. In Troy, Mich., for example, an office building formerly occupied by Ameritech has been on twice and still no takers. “It is so far underwater that no one wants to take that risk,” Emmons says. “Investors are looking for at least break-even cash flow so that they don’t have to come out of pocket to maintain the building.”

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

Beth Mattson-Teig

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