Office Market Madness
Big money and aggressive investors chase deals in unexpected places.
Tulsa, Okla., does not rank high on most commercial real
estate experts’ lists of hot office investment markets. In fact, the 44th
largest U.S. city has wrestled with high vacancy rates for years and
historically has been dominated by private local owners. But in the past year a
number of newcomers, including investment groups from California and Texas, have
turned to Tulsa and other unexpected markets in search of potential office
“The top 30 markets have been so inundated with capital
and people looking for real estate deals that markets like Tulsa have become
interesting to sophisticated investors looking to get in before the market
turns,” says Patrick E. Coates, CCIM, marketing director/broker at Kennedy
Wilson in Tulsa. Capitalization rates in the market are 100 to 200 basis points
higher than those of comparable properties in Los Angeles or San Diego, he
Coates brokered the sale of Tulsa’s TechRidge Office Park
to a Dallas-based investment group. The 550,000-square-foot property sold in
June for $33 million with a cap rate slightly higher than 9 percent. “That is a
prime example of outside investors looking at Tulsa and seeing the potential
for growth and appreciation in our market,” Coates says.
Although Tulsa’s office sector was hit hard by the
economic recession, buyers are taking note of improving market fundamentals:
Office vacancies topped out around 22 percent in mid-2004 but as of May had
dropped to 19 percent, Coates notes.
The scene in Tulsa is playing out in many secondary and
tertiary markets across the country as escalating sales prices and plunging cap
rates in major metropolitan areas are prompting investors to look elsewhere for
higher returns. “In Southern California, you have a ton of money flowing into
Phoenix and Las Vegas, and those markets are going bananas because cap rates
are about 100 basis points higher,” says John Hale, CCIM, SIOR, vice president
and investment specialist at Colliers International in San Diego.
Nationally, office sales activity and pricing continue at
a record-setting clip. Sales totaled nearly $43 billion in the first half of
the year — a 23 percent increase compared to the $29 billion in properties that
traded hands during the first half of 2004, according to Real Capital
Investors flush with capital continue to drive prices
higher and push cap rates lower. Suburban office properties have seen the
biggest increases with prices rising 23 percent in the past year to a national
average of $165 per square foot in the second quarter. At the same time, cap
rates fell to 7.6 percent in the second quarter compared to the 8.0 percent
average a year ago, according to Real Capital Analytics.
Central business district properties remain in demand,
with average sales prices increasing 18.5 percent to $256 psf and cap rates
holding steady at 7.4 percent.
Aggressive Buyers Nab Deals
Institutional investors are stepping up their efforts to
land deals in secondary markets such as Indianapolis. “We had been seeing
pretty healthy competition going on between the 800-pound gorillas — the
pension funds and REITs — and local and regional partnerships,” says Jonathan
M. Hardy, CCIM, vice president of investment advisory services at Coldwell
Banker Commercial in Indianapolis. But lately institutional players have become
increasingly aggressive — and not just on pricing. They’re also structuring terms
to ensure they close deals.
For example, Hardy thought the 675,000-sf National City
Center in downtown Indianapolis was a lock for the local buyer group his
company was representing. The property was built in 1976, and most
institutional players prefer newer properties. But in the 11th hour, Newton,
Mass.–based HRPT Properties Trust came to the table with an unbeatable offer.
Not only was the real estate investment trust competitive on pricing, but it
was willing to put down $8 million in earnest money that was nonrefundable
after four weeks with an additional two weeks to complete due diligence. HRPT
landed the deal, closing on the $70 million purchase in six weeks. “My hat is
off to them. It’s tough to compete with such an aggressive deal structure,” Hardy
The key to getting a leg up in this highly competitive
environment is finding off-market opportunities, he adds. For example, One and
Two River Crossing in suburban Indianapolis sold for $41.6 million in July as a
result of an unsolicited purchase offer from a pension fund. The two office
buildings, which include a covered parking structure, set a new sales price
record in the suburban Indianapolis market of $203 psf.
Locating Viable Alternatives
It’s no secret that quality properties in major metro
markets are commanding top prices. For example, in Miami, New York, and
Washington, D.C., office properties traded at average cap rates of less than 7
percent during first quarter, according to Real Capital Analytics. As a result,
investors are continuing their quest for higher returns by forging into
secondary and even tertiary markets.
For instance, Springfield, Mass., has experienced a spike
in investor interest due in part to its proximity to major markets such as
Boston and New York. “The western part of New England isn’t always at the
vanguard of market dynamics, but over the past 12 to 18 months we have seen an
increase in sales and sale prices,” says Mark A. Berezin, CCIM, CPM, president
of Infinity Real Estate Group in Holyoke, Mass.
Berezin credits the Internet for helping to draw national
investor interest. “There is more information out there, making investors more
comfortable in becoming less geographically bound for investment choices,” he
says. Infinity began using its Web site to entice investors from New York and
New Hampshire about five years ago, and these days the company is landing
clients from as far away as California and Florida. The bulk of investors are
private buyers seeking properties valued at less than $5 million. For example,
Infinity recently represented a buyer from California looking to place $1.5
million in cash in a 1031 exchange.
The increasing competition is putting pressure on
pricing. Springfield has posted double-digit increases in sales prices each
year for the past few years, Berezin notes. Infinity currently is marketing the
55 State Street building in downtown Springfield for $1.8 million, or about $68
psf. The price on the 24,000-sf building is significantly higher than the $1
million the property sold for three years ago, even though the current owners
have added $400,000 worth of improvements to the class B+ office property.
Investor demand for office buildings is so strong that
there is even demand for vacant, half-finished property, Berezin says. Infinity
is listing the 32,000-sf Prudential building in Holyoke for $800,000. A Boston
investor purchased the building two years ago for $240,000 with plans to
renovate and reposition the empty building. But the owner put the unfinished
building up for sale after making about $400,000 in improvements.
Fort Myers, Fla., is another market that has experienced
a surge in investor interest, especially since Lee County reached the 500,000
population mark last year. “It put us on the map for a lot of larger office
users and investors,” says Michael J. Frye, CCIM, owner and commercial
investment specialist at Re/Max Realty Group in Fort Myers. The majority of
investors — 65 percent to 75 percent — are private investors looking to
complete 1031 exchanges, Frye says. “One of the biggest challenges in our
market is finding the inventory. Some of the buildings we have had on the
market are turning over once or twice. But many owners don’t want to sell
because they don’t have a replacement property,” he says.
Sellers Set the Pace
Clearly, the high pricing is encouraging some owners to
put their properties on the block earlier than planned. “We’re seeing a lot of
people who would normally be long-term holds selling properties after a couple
of years,” says Jack Minter, national director of Dallas-based Trammell Crow
Co.’s capital markets group.
Investors are taking advantage of rising values and
turning over properties faster, agrees Ted Buenger, CCIM, an investment
property broker at CB Richard Ellis Investment Properties in Bannockburn, Ill.
For example, the 8501 West Higgins Road property in suburban Chicago sold in
September 2001 for $100 psf and sold again in February for $143 psf — a 43
percent increase over 3.5 years, Buenger notes.
Although the huge demand makes it appear that investment
properties are in short supply, the reality is that the sales market is
extremely active. In Chicago, for example, office sales in 2004 increased 85
percent compared to 2003, and first-quarter sales were up 30 percent over the
same period a year ago, Buenger notes.
One reason for the rise in transaction volume is that a
number of institutions are opting to sell off all or a portion of their
portfolios. Private owners also are selling, sometimes entering into creative
joint ventures that allow owners to tap into a capital source while retaining
ownership. In some cases they also hang onto management contracts, Buenger
says. For example, earlier this year, Dallas-based Prentiss Properties Trust
put a 2.9-million-sf office/industrial portfolio on the market and the company
expects to retain part ownership, he adds.
In addition, “Sale-leasebacks were at a record level last
year,” he says, as corporations look to trade ownership for capital. “More
corporate facilities are being sold, as corporations don’t want to have their
capital tied up in real estate.”
Sales and pricing remain under pressure in areas where
there is a limited supply of new buildings to buy. For example, mature markets
such as San Diego lack available land on which to build new office properties.
In addition, few owners are willing to put their properties up for sale because
it is challenging to find quality replacement product. “Owners would love to
take advantage of high prices and sell, but then they have to turn around and
pay high prices in order to reinvest. It’s almost like gridlock,” Hale says.
Are Buyers Paying Too Much?
Many industry insiders question if buyers are paying too
much for properties, particularly since office vacancies remain in the teens in
many cities. “The market has been whipped into a foam at this point. We have
been advising our clients to enter into that fray with a lot of caution,” Hardy
“Every cycle has people buying properties that are wise
and certainly some people are buying properties they shouldn’t,” Minter agrees.
But for the most part leveraged returns are holding steady thanks to continued
low interest rates. Historically buyers have paid about 400 basis points over
the 10-year U.S. Treasury for real estate. Based on the current Treasury, which
has been hovering near 4 percent, that creates an internal rate of return
around 8 percent, he adds.
Some investors simply have adjusted their expectations to
accommodate the higher pricing and are willing to take lower returns. Other
buyers hope that improving office fundamentals will justify the higher prices.
“San Diego does have rents ticking up and leasing velocity, so we have seen
very aggressive underwriting,” Hale says. The market is posting some of the
lowest office vacancies in the country, with second quarter averaging 9.3
percent. In an effort to control property, some investors are willing to buy at
a low return now and gamble that future rent increases will boost returns in a
Still other buyers are seeking deals outside the overheated
U.S. market. For example, opportunity funds have been buying in Europe and Asia
for years. “Before they accept returns that we have here in the United States,
they will go out and look for product all over the world,” Minter says.
Voracious Demand Continues
The huge demand for office properties does not appear to
be waning. Several factors have contributed to the rush for office investments,
including signs that the economy is improving, which bodes well for office
occupancies. “The job outlook continues to be favorable, albeit not nearly as
robust as during the late 1990s,” says Alan Pontius, national director of
Marcus & Millichap’s office and industrial properties group in Encino,
Despite the Federal Reserve Board’s steady interest rate
hikes over the past two years, long-term lending rates have moved very little,
hovering around 4.1 percent at the end of July. “We continue to have a very
favorable interest rate environment,” Pontius says. In addition, capital
continues to pour into real estate because there simply are no viable
investment opportunities due to dismal stock market gains.
Office also is attractive right now because it is just
beginning to move into its recovery cycle, signaling that now is the time to
buy. “That is exactly the reason why investors are bullish today on Northern
California, specifically the San Francisco Bay area,” Pontius says. Investor
interest in the Bay area is increasing rapidly, but not because of huge
improvements in rental rates or occupancies. In fact, San Francisco continues
to be one of the weakest office markets in the country with suburban vacancies
at 20.8 percent. Many investors are banking on the fact that historically the
area’s office market has been strong and a recovery is underway, he says.
Elsewhere the looming office market recovery is prompting
value-added buyers to bid for buildings despite significant vacancies. “Real
estate, especially the suburban markets, has been suffering pretty severe
vacancies for the last three years,” Buenger says. However, those market
conditions are beginning to turn. For example, in suburban Chicago,
second-quarter vacancies dropped to 18.3 percent compared to 19 percent a year
ago — a very positive sign.
While there have been distinctive signs that recovery is
in motion, the competitive climate in today’s marketplace also is forcing
buyers to take a more aggressive — and optimistic — view, Pontius says. In this
competitive bidding environment, certain transactions are closing in which
projected yields will not be met if office vacancies and rents don’t improve as
anticipated. “There is a level of aggressiveness that stems from the belief
that we are in an economic recovery and certainly a hope that the recovery will
accelerate and be much more rapid going forward than it has been to date,” he
Interest Rates: The Wild Card
Barring any unforeseen events, interest rates are the
main factor that potentially could impact transaction activity. Even though
there is a lot of talk about rising interest rates, “valuations are not going
to change until there is some kind of sustained change in the level of the
10-year Treasury,” Pontius says.
How high rates will have to rise to have an effect on the
market and how quickly the impact will be felt are unknown. During the last two
years, the Federal Reserve’s gradual 0.25 percent interest rate increases have
not had much of a cooling effect. As interest rates rise, investors appear
willing to lower their return expectations. “We are getting to the bottom of
that willingness to take lower returns and I think caps will have to tick up,”
the most likely scenario in the coming months is that office properties will
continue to trade at or above current levels. “There is a lot of money that is
very eager to find a home in real estate,” Pontius says. “Right now a 6 percent
return in a real estate asset sounds pretty good in the global landscape of
returns, especially if you believe there is building pressure on the income
side of operations.”