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For Investors, Not All Class A Office Assets Are Alike

High-Occupancy Class A Buildings Outperforming Low-Occupancy in Pricing, Absorption, Rents
December 1, 2010
Despite the common perception that investors are bidding up prices for any major Class A office building brought to market, an analysis of recent sales activity finds a decided risk aversion to high vacancy among Class A office investors.

Call it an occupancy premium or cash flow premium, but investors appear very discerning in what they are willing to spend. Just as there is a clear bifurcation in the office investment market between core and noncore properties and markets, there also appears to be a clear bifurcation among core Class A office properties.

Values for Class A office properties with low occupancies and their related lease-up risk remain under pressure, while similar properties with high occupancies are going for huge premiums - an indication that the appetite for risk remains low even in core assets.

Assets with quality cash flows in primary markets such as New York, D.C., Boston, and San Francisco have fetched some eyepopping prices this year. The weighted average price per square foot for core assets in primary markets in the second quarter increased by nearly 44% from the previous quarter and it appears the trend continued in the third quarter.

As one example, in September Generali Immobilier bought the 146,648-square-foot office building at 900 17th St NW in Washington, DC for $93.5 million or $637/square foot. At the time of purchase the building had just a 2% vacancy.

But then compare that pricing to what high vacancy buildings are going for. First Potomac Realty Trust paid $13.66 million in April for a Class A, 180,000-square-foot building across the Potomac in Fairfax VA, - a little less than $76 per square foot. The building had an 89% vacancy rate at the time of purchase.

That disparity in prices between high- and low-occupancy office properties was found throughout Class A office property sales in the last four quarters, according to data from CoStar Group, Inc.

Class A office buildings with vacancies of 5% or less (virtually full buildings) were selling for an average of $327/square foot between Oct. 1, 2009, and Sept. 30, 2010. On the bottom side, Class A office buildings with vacancies of 95% or more (virtually empty buildings) were selling for an average of one-third of that -- $118/square foot.

Examining this trend further, Class A office buildings with occupancies of 80% or more were selling for an average of $266/square foot, while buildings with 79% occupancy or less were going for $162/square foot.

This discrepancy between and high- and low-occupancy Class A asset prices is also showing in building performance and rents as well.

Class A properties with occupancies of 80% or more purchased between Oct. 1, 2009, and Sept. 30, 2010, posted net absorption over the past four quarters of nearly 4 million square feet. The average vacancy rate of these buildings has dropped from 11% to 6%. Average asking rents have increased from a low of $28.29/square foot to $29.50 in that time.

On the opposite end, Class A office buildings with 79% occupancy or less posted negative net absorption 1.24 million square feet. The average vacancy rate of these buildings has increased from 44% to 50%. Average asking rents have decreased from a high of $25.76/square foot to $25.28.

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