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Going Coastal

Sam Zell launched his storied real estate career in Ann Arbor, Mich., flipping apartment buildings in the 1960s. Since then, Chicago-based Zell has bought and sold scores of office buildings.

While his latest dispositions have coincided with a strong seller's market, Zell has publicly voiced larger concerns about the future of several real estate markets in the central U.S. Specifically, Zell believes that many of the largest cities in these markets will lose chunks of their population to several growing coastal cities.

“Some major changes are taking place in society,” remarked Zell, chairman of Equity Office Properties Trust, during a New York University-sponsored REIT conference in Manhattan. “Among them is the trend of more people staying single longer. We're seeing a larger number of unmarried people with disposable income, and that is translating into a series of dynamic, 24/7 cities.”

In November 2004, Equity Office sold off its 4.2 million sq. ft. Dallas portfolio — and that chunk represented 3.4% of the firm's total portfolio nationwide.

Proceeds from these sales have financed several big coastal deals. In April, Equity Office closed on midtown Manhattan's Verizon building for $563 million. Equity Office isn't alone, as other REITs have increasingly sold off Midwest-based assets. Data from Real Capital Analytics shows that REITs divested of roughly $5.7 billion in Midwestern office properties in 2004 — a net increase of more than $1.3 billion over the 2003 level. With some minor exceptions, investor confidence in coastal markets is validated by the fundamentals. Grubb & Ellis data shows that the steepest vacancy declines between year-end 2002 and 2004 occurred in coastal markets. Office vacancy in Palm Beach County, Fla., dropped 620 basis points, from 17.3% to 11.1% during that period. Orange County, Calif., meanwhile, came in second with a 490-basis point decline, from 16.4% to 11.9%. Orange County posted the strongest rental growth during that period, with average asking rents rising 15%, from $24.48 per sq. ft. to $28.16 per sq. ft.

Why are institutional investors so determined to pour money into coastal cities? For starters, markets such as New York, Los Angeles and Miami are international gateways with physical growth barriers. They are also magnets for immigrant labor, not to mention huge shipping hubs. In southern California, the strength of the entertainment, defense and biotech industries helps keep the region's economy humming.

One problem that secondary markets face is the offshoring of jobs. That didn't matter much a decade ago, but that was before Manila and Mumbai were siphoning off call center jobs in Iowa. “What effect will these changes have on call center space in Des Moines? The answer is it won't get filled,” said Zell during the conference.

“When you consider globalization, it's the large cities on the coast that benefit most. You also don't see foreign investors pouring much money into Midwestern real estate,” says Peter Korpacz, director of Pricewaterhouse Coopers' real estate research group.

Foreign capital favored three U.S cities in 2004 — Washington, D.C., followed by New York City and Los Angeles. Interest in these coastal markets has driven prices up considerably over the past three years, and that's quite a contrast to the Midwest [see chart]. Meanwhile, Chicago came in sixth place after both San Francisco and Miami, reports the Association of Foreign Investors in Real Estate (AFIRE).

“Most investors have had a bi-coastal strategy for a while,” says Tony Pierson, managing director of portfolio management at Cornerstone Real Estate Advisers LLC. What has changed, says Pierson, is that the capital markets have become increasingly global. He doesn't see that slowing down either, which suggests that core markets along the edge of the United States should remain liquid for years to come.

“You have these huge cities with massive populations,” says Paul Briggs, a senior economist at Boston-based Property & Portfolio Research. “So when you ask an investor looking to hold an asset for a long time where they want to be, they will say on the coast. It's a real draw, and it also gives investors an exit strategy.”

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