Suburban Office High
These Properties Outside the CBD Offer Peak Performance and Long-Term Investment Potential.
Where will you find the highest office rents in the nation? Manhattan? Washington, D.C.? Try Sand Hill Road in Palo Alto and Menlo Park, California, where tenants are paying $70 per square foot (psf) for class A space, according to figures from Equis Corporation in Chicago.
Although somewhat exceptional due to the boom in surrounding Silicon Valley, Palo Alto and Menlo Park still are indicative of the action in prime suburban markets throughout the United States. Despite a much-lauded comeback of urban downtowns, the top office markets remain outside the city limits in most regions.
"We’re high on suburban markets," says Nina Gruen, a partner in Gruen & Gruen, a real estate and economics consulting firm in San Francisco. In its 1997 year-end summation, the firm gave suburban office product three stars out of a possible four-star rating. (Four stars went to seniors housing, assisted living, and specialty retail.) Building Owners and Managers Association (BOMA) International in Washington, D.C., forecasts that suburban office will be the top-performing real estate investment product over the next five to 10 years.
While observers give the category high marks for both performance and long-term investment potential, at the same time, many analysts express caution in the short term, warning that prices appear to have peaked or be near peaking in some markets. In other markets, high levels of development threaten to slow rent escalations and potentially lead to overbuilding.
"You have to look at each micro-market to determine where it is in the investment cycle," Gruen says. "I think in general we are toward the top part of the cycle. I don’t know if we have reached the top, but we’re certainly more than 50 percent there, so I would look at each market with great care."
In the long run, however, the suburban office sector should do quite well, she adds, citing several factors that favor the category in terms of future growth. Foremost among them is a growing desire by employees to avoid long commutes by working near their homes. Since the suburbs absorbed the majority of residential growth in the past half-century, most employees are suburban-based.
Moreover, the majority of office jobs are also suburban-based. Suburban offices account for 60 percent of the nation’s total inventory and up to 80 percent of total net absorption since 1980, according to the spring 1998 issue of CB Richard Ellis Market Watch. Also contributing to suburban viability is the decreasing need for face-to-face interaction due to technological advances, Gruen adds. Wider use of videoconferencing and teleconferencing, e-mail, and other modern communication tools means that businesses have less need to cluster in downtowns for convenient access to each other’s services.
Downtown versus Suburbs
Ironically, the suburbs owe at least some of their current success to the renewed strength of downtown markets. In fact, Rick Gallitto, New England office regional director of Finova Realty Capital in Boston, calls the turnaround in downtown markets and resultant rent increases the primary reason for suburban strength.
"There’s a lot of overflow from downtown firms looking for back-office space at more affordable rents," he says. Where suburban rents match downtown rents, suburban tenants often turn out to be firms squeezed out of the city by a simple shortage of space, he adds.
The CB Richard Ellis Market Watch, on the other hand, takes the opposite view. It attributes the downtown revival to suburban saturation, rather than the reverse.
However, brokers in the field tend to share Gallitto’s view, including one in CB Richard Ellis’ San Francisco office. According to Bill Walsh, CCIM, a senior vice president, high rents and a shortage of class A and B space are forcing small firms to move out of San Francisco.
In New Orleans, pressure from a different source is pushing tenants to the suburbs, says Colleen Berthelot, CCIM, SIOR, an associate broker with Corporate Realty, Inc., in Metairie, Louisiana. "Hoteliers and historic preservation people have purchased class B properties downtown and converted them to hotels, residences, etc. Tenants who used to be in those buildings were forced either up to class A, filling up those buildings, or to the suburbs," she says.
Conversion of class B buildings to hotels and residences is occurring in New York, Philadelphia, Chicago, and other cities as well. Class B and C buildings in major cities also are attracting the attention of retailers. All of this puts more pressure on downtown office markets, driving tenants who cannot pay class A rents into the suburbs.
But fewer corporations are choosing established suburbs over downtown areas on the basis of rental rates, because suburban and downtown rents are approaching parity in many markets, at least for class A space. The major cost differential is parking, Berthelot says, because parking is included in suburban but not downtown rent.
Traffic also is less a factor than it used to be in choosing between downtown and the suburbs. "Suburban markets are densifying and developing their own urban problems," says Jeffrey S. Lyon, CCIM, vice chairman of Kidder, Mathews, & Segner, Inc./Oncor International in Tacoma, Washington. As a result, suburbs are expanding to locations farther and farther from the city they orbit.
In the Seattle area, "We’re seeing development occurring up and down the I[nterstate]-5 corridor and then seeing it go east along I-90. A couple years ago, no one would go out there," Lyon says. Now, "Major corporations that have been in downtown Seattle or Bellevue are moving 15 and 20 miles out." He points to Santa Clara, California-based Intel Corporation’s decision to build a large research and development (R&D) facility in DuPont, Washington, about 10 miles south of Tacoma, as an example.
Although rents in these fringe areas are significantly lower, Lyon says that the availability of land is a greater attraction than low rent. The fastest-growing companies, he notes, are high-tech firms, which tend to prefer campus settings over high-rise buildings. That in itself requires large chunks of land, but growing firms also want surplus land to allow for future needs. Generally, only the outer suburbs can meet that requirement, he says.
Suburbs Outperform CBDs
All performance indicators point to a strong market sector. The suburban office sector ended last year with an average vacancy rate of 9.3 percent, compared to 12.3 percent for the central business district (CBD), reports Valuation International, Ltd., (VIL) of Atlanta in its publication Viewpoint 1998. The quarterly MarketIntelligence Report, published jointly by BOMA International and Cushman & Wakefield, put the suburban figure more than two points higher but still below the CBD level.
Another strong sign is that average sales prices and rents were up in 1997—a 14.3 percent rise in average sales price and a 9.6 percent rise in average rent, according to the National Real Estate Index, published by CB Richard Ellis in association with E&Y Kenneth Leventhal Real Estate Group. The average rise in office rents, both urban and suburban, has run about 6 percent annually, nearly triple the rate of inflation. CB Richard Ellis also reports that rental increases in the suburban sector were double and triple those recorded for the apartment, warehouse, and retail sectors. Only the CBD office sector, with a jump of 15.9 percent, fared better.
Specific areas show signs of strong performance, too. In Dallas, the suburban market occupancy level climbed to about 91 percent from 86 percent a few years ago and 82 percent in 1990, says Cheri White, CCIM, senior vice president of Davidson Conine Realty Advisors, Inc., in Dallas. Rents have reached $25 psf to $28 psf in the better markets, about the same level as downtown. However, she notes that the suburban Las Collinas area boasts rents of $32 psf to $35 psf, the area’s highest.
Denver vacancy rates have fallen from near 30 percent to 5 percent in some submarkets. "The suburbs led the charge," notes Bill A. Conway, CCIM, senior director of the Financial Services Group in Cushman & Wakefield’s Denver office.
The story repeats itself in the northern Virginia suburbs. Rents have doubled since the early 1990s, says Jeff Salino, CCIM, leasing and marketing manager for Compass Management & Leasing, Inc., in Arlington, Virginia. "In Tysons Corner, you’re looking at $26 [psf] and up. If you think back to the worst of the market in ‘91, the same space was going for $13 and $14—if you were lucky," he adds.
Suburban markets appear to be doing well in all regions. Of the 54 suburban markets tracked by CB Richard Ellis, 46 showed single-digit vacancy levels at the end of 1997. Of 41 non-CBD markets tracked by Cushman & Wakefield, only 10 saw vacancy rates move upward last year. Only three—Philadelphia, Los Angeles, and Bellevue—saw average rents decline. Fifteen markets had negative absorption, according to Cushman & Wakefield, mostly due to completion of new spec buildings that had not had time to reach lease-out. Seven markets absorbed more than a million square feet (sf). Suburban Houston led with 2.2 million sf absorbed.
Most analysts place the San Francisco Bay Area at the top or near the top of all the country’s suburban markets. With a vacancy rate of less than 2 percent, according to CB Richard Ellis, the San Francisco peninsula has the nation’s tightest major market. Neighboring Silicon Valley, with a vacancy rate of less than 5 percent, is among the top five. Some submarkets have virtually no space. The Bay Area has four of the six top suburban markets in terms of rent, according to Cushman & Wakefield. The exceptions are West Los Angeles at third and northern New Jersey at fifth.
Not surprisingly, Bay Area investment has been high, with real estate investment trusts (REITs) particularly hungry for product. Brokers routinely report five and six serious offers for properties. Gary Willard, senior vice president for CB Richard Ellis in Foster City, California, fielded 17 offers for one listing.
The scramble has resulted in record-breaking sales in several northern California communities. For example, in March, Equitable Life Assurance Society of the United States sold Growers Square, a 191,000-sf, three-building office complex in Walnut Creek, California, to Invesco Realty Advisors for $41 million. The nearly $215-psf price was the highest ever paid on the east side of San Francisco Bay. In December, Divco Properties paid $252 psf for the 107,000-sf Century Centre in San Mateo, California, a record for the peninsula.
Markets in several other regions are showing similar record-setting activity. Prices for trophy properties in top Westchester County and southern Connecticut locations are $275 psf to $350 psf. Jones Lang Wootton notes that the four 1997 sales in Chicago’s northern suburbs were "well above" $200 psf.
Houston led the suburban field in the number of sf sold last year, with 21.45 million sf changing hands, according to Cushman & Wakefield. The closest competitor was Los Angeles, with 16.59 million sf sold. Four other suburban areas—in Boston, Dallas, Chicago, and Philadelphia—recorded more than 10 million sf in transactions.
Cap rates have dropped considerably from a few years ago. In Denver in the early 1990s, cap rates of 8 percent to 10 percent were par for the course for quality office product with vacancies, yielding prices of $50 psf to $70 psf, Conway says. Today, cap rates on fully leased properties are in the 6.5 percent to 8 percent range, yielding prices of $80 psf to $110 psf, while new buildings that are fully leased have cap rates of 9 percent to 10 percent, yielding $120 psf to $150 psf. Some buildings are selling even higher, he adds, pointing to a recent purchase in the Denver suburbs by Bedford Property Investors, Inc., for $170 psf.
Scot Farber, CCIM, a vice president in Jones Lang Wootton’s Dallas office, calls cap rates "very aggressive." He says it is not uncommon to see cap rates below 7 percent, and even below 5 percent for trophy properties and large portfolios, in markets just beginning to catch fire. But he adds that cap rates start climbing when sales prices begin to approach replacement costs.
While all of this is great news for current owners, buyers may want to hesitate before jumping into the suburban pool. Observers have posted warning notices that the level of construction planned for the next few years almost certainly will slow rent increases. The better investment opportunities, they suggest, lie downtown. Suburban development typically precedes urban development because lower land costs, greater availability of sites, fewer restrictions, and lower construction costs (due to the preference for low- and mid-rise structures) make it cheaper and easier to build outside the city. Consequently, the suburbs are seeing new product before the cities.
Two years ago, almost all new office construction was build-to-suit, but in the past year speculative building has come on strong. In the most competitive markets, build-to-suit construction still is active, but is slowing down as developers bring more spec product on line. Build-to-suit still makes the most sense for companies with unusual needs that cannot be met in the standard market or those that want their own corporate campuses, Lyon says. It also makes sense in markets that are lagging.
Lyon reports significant new office development planned for the Puget Sound region of Washington State. "We’re seeing developments of 200,000 sf and up announced almost every day for the whole eastern part of King County," he says. Replacement costs in the suburban markets range up to $150 psf to $175 psf, he adds.
In Miami, some four million sf of new space is planned for the Coral Gables area and more than seven million sf around the Miami International Airport, says Sandra Goldstein, CCIM, president of Sandra Goldstein & Associates in Key Biscayne, Florida. Rents are pushing upward, she says, but vacancies have declined only slightly. Nonetheless, she believes that the market will be able to absorb the new space.
Developers started spec building in the Dallas area three years ago, according to White. Investors already have begun to shift their focus to Houston. "Traditionally, Dallas lags behind Atlanta by about two years and Houston lags behind Dallas by about the same," she says.
Many investors who picked up suburban office buildings prior to 1996 have been able to turn them around for sizable profits. In the Growers Square example in Walnut Creek, Equitable netted $16.5 million on the $24.5 million it paid for the property in late 1994—a 67 percent jump in a little more than three years.
Investors anticipating the same results four years from now are likely to be disappointed. "[M]ost of the upside has already been realized in the suburbs," reports Viewpoint1998. The report went on to call 20 percent or higher returns "a thing of the past," noting that such large profits were made possible by the purchase of real estate-owned (REO) properties at bargain-basement prices. Today REOs are rare, says Jim Henry, CCIM, a partner with JHL Commercial Properties in Fairfield, California. "We represent a number of banking institutions. Their REO portfolios are nonexistent," he reports.
Today’s suburban markets primarily favor long-term investors seeking steady returns rather than those wanting quick cashouts, most analysts say. Some have warned investors, however, to exercise caution on properties with significant leases set to expire early in the next century. They calculate that rents in most major suburban markets have peaked or soon will because of the amount of new construction planned.
At the end of 1997, almost 75 million sf of office space was under construction, according to a Merrill Lynch report. At least 80 percent of that was in the suburbs. On Cushman & Wakefield’s list of 41 suburban markets, 27 added sf in 1997. Atlanta led by a wide margin with 5.22 million sf of new office space. Denver was next with 1.89 million sf, followed by Phoenix with 1.81 million sf, and Dallas with 1.72 million sf. The other 23 added less than a million sf each.
Cushman & Wakefield has posted warnings for both suburban Atlanta and suburban Dallas, noting that first-quarter vacancies climbed a half-point in the former and nearly a full point in the latter. So much building has occurred in Atlanta, Farber says, that cap rates are back in the 9 percent range. Cushman & Wakefield issued lesser warnings about the San Jose, California; Boston; and northern Virginia suburbs.
At the same time, some regions are further from peaking. Most of the 1.9 million sf absorbed in suburban Denver last year was leased before it was completed, Conway says. He predicts that the region quickly will absorb the nearly 2.5 million sf now in the pipeline.
VIL estimates that it will take suburban Denver until 2003 for supply to outpace demand. The appraisal and consulting firm made the same forecast for the suburban markets of Charlotte, North Carolina; Kansas City, Missouri; Pittsburgh; and Los Angeles. Suburban markets not likely to peak before 2001 include Atlantic City, New Jersey; Dallas; Honolulu; Long Island, New York; Minneapolis; New Orleans; Orange County, California; and San Antonio. VIL rated all other major suburban markets two years or less from peaking.
Financing for both acquisition and development is plentiful. Most sources call it a true buyers’ market, with lenders fighting for deals. Don Eaton, vice president of Argus Financial Corporation in San Mateo, says that a half-dozen lenders competed strenuously to provide construction financing for Woodside Technology Center, a 252,000-sf office/R&D complex in Redwood City, California. The developer, a local partnership, opted for a pension fund because it was willing to undertake a construction-takeout combination with a fairly generous 12-year term.
The competition among lenders has led to sweet deals for borrowers. Principal Financial Group "jumped at the chance" to provide $20 million in refinancing for the 238,550-sf Landmark Office Center in Mountain View, California, according to Jim Henderson, an Argus vice president based in San Mateo. The Des Moines-based lender offered a fixed rate of less than 7.5 percent with a fully amortizing 20-year term. "Since the property is 15 years old, it was especially attractive," he says.
Nyal Leslie, a partner with Los Angeles-based PacTen Partners, says his company had no trouble getting a construction loan for Glendale Plaza, a 525,000-sf office tower in Glendale that will be the first spec office project to start construction in the Los Angeles basin this decade. PacTen attracted Morgan Stanley as an equity partner in the deal, which ensured that the project would land construction financing at what Leslie termed a "very competitive rate."
The partners have not decided on an exit strategy, but Leslie notes that "There are people approaching us daily to buy it now, everything from REITs to opportunity funds. Investors are very active." Whatever exit strategy is selected, it will not be to sell before completion, he says. "We think the market is ready to move up and expect the project will increase in value quite quickly."
The financing market for multitenant office buildings in general is somewhat less competitive than other categories because transactions tend to be more complex, Finova’s Gallitto says. "The way the loans are underwritten makes them more complicated. You have to look at tenant rollover costs, leasing commission costs, the credit quality of tenants, all of that," he says. Despite the complexity, he says Finova welcomes office financing opportunities. "Like many lenders, we have a tremendous appetite for all product types."
Capital is available for almost any type of product today, including suburban office, Farber says. "In past years, we would talk to groups that had $100 million to invest. This amount has now been increased to $500 million to $1 billion." The suburban market looks particularly strong. "Suburban properties will continue to be a good investment because fundamentally they are a part of our society," he says. "Unless there is significant overbuilding, which I do not expect, the long-term prospects are excellent."