Office: Risk vs. Reward
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 Co.in
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 Auction.com 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.”
Mattson-Teig is a business writer based in Minneapolis.