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Distress? What Distress? 5 Office Markets Attract Top Dollar for Prime Assets

Class A Office Properties in Boston, NY, DC, San Fran & LA Thriving on Cash-Rich Investors
July 7, 2010
SL Green recently paid $193 million, or $636 per square foot, for 600 Lexington in New York City. The office REIT also secured the Canada Pension Plan Investment Board (CPPIB) as its joint venture partner in the trophy asset.
SL Green recently paid $193 million, or $636 per square foot, for 600 Lexington in New York City. The office REIT also secured the Canada Pension Plan Investment Board (CPPIB) as its joint venture partner in the trophy asset.
For all of the talk of distress in commercial real estate, you won't hear the "D" word mentioned among investors clamoring for top-quality office properties in at least five markets. Investment activity in institutional-quality office properties in Boston, New York, Washington DC, San Francisco and Southern California is thriving. And strong investor interest is also evident for the highest quality office propertis in other markets as well, although a huge canyon separates those select properties from other office classes in most markets.

"There is a Grand Canyon gap in value disparity between "A" properties and everything else," said Fred B. Cordova III, senior vice president / CART Western regional director at Colliers International in Los Angeles. "The private REITs are pushing pricing on quality product across all product types, but steering clear of anything below investment grade."

In an examination of 216 office deals of more than $10 million for single properties of more than 100,000 square feet since January 2009, CoStar Group found that the five markets listed above accounted for more than 70% of the deals by dollar volume. The total dollar volume of the 216 deals was $14.75 billion.

New York Metro: $4.17 billion
Washington DC Metro: $3.05 billion
San Francisco Bay Area: $1.2 billion
Southern California: $1.07 billion
Boston Metro: $893 million

REITs, both private and public, accounted for about $3.35 billion of the investment activity by dollar volume, but 25% of the deals by count. Other active buyer types included private equity and pension funds.

"Most are all-cash buyers, with debt placed after the fact," Cordova said. "The active buyers in the West are mostly REITs and are pushing pricing for top-tier product as a strategy to upgrade their portfolios at a significant discount to replacement cost with the expectation that there will be a flight to quality for top-tier tenants."

"As regulated buyers, most REITs keep their debt at or below 60% loan-to-value. At that level, with strong balance sheet sponsorship, debt is very available and cheap for top tier product with stabilized rent rolls at market rates," Cordova said.

The investment activity has picked up notably in the last nine months, said Richard Egitto, senior managing director of Crimson Services LLC in Littleton, CO.

"Activity is driven by a combination of public core investors in the U.S. having waited a long time to be able to invest after raising funds to buy these products in 2007, 2008 and 2009," Egitto said. "Private REITS such as Cole Companies out of Phoenix that raise money from a vast network of retail brokers are attaining so much money ($1 billion a year) they have had to expand from simply buying retail into buying core office product in order to move the money out that they have and make room for the additional money they raise every day."

William E. Jones, vice president and appraisal manager at Far East National Bank in Los Angeles, said that the perception of investors is "that prime U.S. real estate is a better bet than anything else. It is considered a good inflation hedge, and unlike gold it yields a dividend."

"What's driving the quest for Class A properties is a whole lot of cash that no one really knows what to do with. Put it in the stock market? Are you crazy? Buy bonds and get a yield of (maybe) 3%? (I think U.S. Government 10-year was briefly below 3%!) No way!" Jones said. "That leaves real estate. There is a lot of dough chasing a very few good deals."

The demand for office properties in these markets is especially apparent "for offices with high occupancies and long-term leases in place," said Stephanie Hession, a real estate economist for CoStar Group who covers the Washington DC, market. "A handful of office buildings in downtown Washington DC have sold for more than $500 a square foot this year, which was the weighted average price at the peak of the market three years ago."

In comparing what is happening in the investment market for prime office properties versus all office properties, the overall weighted average price for the 70 buildings traded in the Washington metro area in the second quarter was $350 a square foot. That was similar to the third quarter of 2008, but still 30% less than the 2007 peak, Hession said.

"There's already year-over-year job growth in this metro, asking rents have held up pretty well, and absorption has been positive recently thanks to federal government and related expansions," Hession said. "As a result, investors see Washington DC as a safe haven, and there is a lot of competition for well-leased assets. Owners that need cash sell because they can get higher prices here than in most other markets."

Why Other Markets Aren't Selling
The same property and market fundamentals are not as apparent outside of the five markets examined -- not even for such major markets as Chicago.

"Chicago has been experiencing declining office rental rates in constant dollar terms since 2001 and declining occupancy rates," said McKim N. Barnes, senior vice president-research and analysis at Draper and Kramer Inc. in Chicago. "And the job counts in Where Workers Work (put out by the Illinois Dept. of Employment Security) indicate no growth in the Chicago region and in Chicago's downtown. Without job growth, how will there be rent increases in real terms?"

Jones of Far East National Bank, said he has "noticed no spillover effect to B- and C-level properties in sluggish markets. There, the mindset of buyers/investors is the opposite - no one seems to want to pay the asking price for an asset which is less than the price in a less-than-prime location. They may bid the asking price, but then they'll find all sorts of ways to negotiate the price down - problems with the property, potential liability issues, etc."

Anthony Homer, a commercial associate with LWR Commercial Realty in Lakewood Ranch, FL, said there is another reason the activity has not trickled down so far.

"Most of the Class A office properties in smaller markets, like ours, are owned by privately held firms or single owners. There has been a trend among national and local tenants of moving 'up the food chain', into the most desirable office properties," Homer said. "Couple these factors with a lack of comparable investment alternatives and there is little motivation for these landlords to sell performing assets. That's what we're seeing in our market and I think the same factors apply in many of the secondary and tertiary markets in Florida."

CoStar's Hession says that interestingly enough, the trend is reversed in the struggling Southern markets, with higher-vacancy properties changing hands.

"High-vacancy Southern markets including such markets as Dallas-Fort Worth, Houston, Atlanta, Phoenix, Tampa, and South Florida have yet to see an uptick in investment, and about one in four of this year's deals in those markets has been distressed," Hession said. "Properties that last sold during the peak are holding up a bit better, although vacancies are still extremely high compared to the favored [markets]. This suggests that sellers are throwing in the towel and dumping their poorly performing assets in these markets. The buyers of these assets, however, appear to be using their lower basis to buy occupancy. The vacancy rate in these recently purchased assets has been declining since the beginning of 2009, even as properties sold from 2006-07 continue to see occupancies erode."

"As investors get frustrated with the fierce competition for core assets in the primary markets, they will begin to move out along the risk spectrum, either acquiring higher-occupancy properties in secondary markets or more value-add deals in primary markets," Hession said. "When the capital train approaches those stops, pricing and competition will rise accordingly, particularly as job growth, leasing, and absorption become more apparent and vacancies begin to crest."

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