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Why Office Owners Can't Resist the Quick Flip

Private real estate investment funds that have snapped up office buildings over the last couple of years are increasingly becoming masters of the flip. Case in point: Boston-based Beacon Capital Partners, a real estate investment firm that owns 13 million sq. ft. of office space in major markets on the East and West coasts, purchased the 55-story, 1.4 million sq. ft. BP Plaza in downtown Los Angeles for $270 million in August 2002.

In quick fashion, Beacon Capital re-signed a major tenant to 350,000 sq. ft. and sealed an agreement that generated an extra $500,000 in annual parking revenue. Then it signed up Bank of America for 197,000 sq. ft. and renamed the edifice Bank of America Plaza.

In June 2004, Beacon Capital put the building on the market. Two months later Chicago-based Trizec Properties paid $435 million for the property, providing Beacon Capital with a whopping $165 million gross profit.

Beacon Capital completed another quick flip in October of 2004 when it sold Trillium East and West in Woodland Hills, Calif., for $162 million to Douglas Emmett & Co., a full-service real estate investment and management firm based in Santa Monica, Calif. Beacon Capital, which acquired the 655,000 sq. ft. complex in September 2001, made a tidy gross profit of $28 million in that deal. And the kicker? The buildings weren't on the market, says Alan Leventhal, Beacon Capital's CEO.

“We typically like to hold assets for the long term,” says Leventhal, who plans to increase the firm's office portfolio to 20 million sq. ft in 18 months. “But certainly there have been dramatic changes in the marketplace, so we've been selling assets that we expected to own longer.”

Shifting Philosophy

Beacon Capital is hardly the only office investor taking advantage of the frothy capital markets which are driving up values and creating a seemingly limitless investor appetite for property. New York-based real estate investment research and consultant firm Real Capital Analytics, which tracks sales of $5 million or more nationwide, says that 2,070 office buildings sold in 2004. Of that activity, some 270 transactions, or 13% of all sales, involved assets that had been held approximately four years or less. Those 270 transactions alone generated an aggregate gross profit of nearly $3 billion.

While corporate owners and small opportunistic value-add investors accounted for some of the sales, the list is also peppered with the names of several large national and regional landlords that manage funds for pension plans, endowments, private foundations and other deep capital sources. Some of the names include Houston-based Hines, San Francisco-based Shorenstein Co., Chicago-based Walton Street Capital, and Newark, N.J.-based Prudential Real Estate Investors.

So, are private investment funds turning into short-term holders of office assets in return for fast profits, or are they simply taking full advantage of the wide-open capital spigot that's flooding the property markets?

A little bit of both, according to experts. Yes, the capital markets are fueling rapid-fire transactions. But increasingly, portfolio managers are earning financial rewards for seizing opportunities that return big profits. In turn, that has generated typical ownership periods of five to seven years compared with hold periods of about 10 years that were common a decade ago.

“There's an expression that if you didn't sell the asset, then you bought it again,” says Michael Straneva, a partner in charge of hospitality and real estate analytics in Ernst & Young's Phoenix office. Translation: If owners fail to take advantage of the current seller's market today, they may have to accept a lower price tomorrow. “Owners take that seriously, and they're taking a more active management approach with their portfolios.”

Certainly fund managers aren't resisting a hands-on role: Typically they receive a share in the portfolio's returns. In fact, Hines receives such incentives for its management role in San Francisco-based National Office Partners, a partnership that Hines and the California State Employees' Retirement System (CalPERS) formed in 1998 to acquire and operate office properties. Generally, Hines receives a 20% share of the internal rate of return over and above a threshold of 9.5%, though Hines also must meet other performance standards to qualify for the incentive.

The incentive structure is part of a nearly 20-year shift in real estate asset management, explains Dan MacEachron, a senior vice president of Hines in the firm's San Francisco office. Fifteen years ago, for example, compensation generally wasn't tied to the investment returns of a portfolio. Instead, investment advisors would buy assets for a pension fund, for example, and would typically receive straight fees for services such as acquiring, managing and leasing the properties.

“Back then the economics for the investment advisors were such that advisors thought, ‘We've got this fee-based income stream, why would we want to sell?’” MacEachron says. “When you have some sizable incentives that can be earned for the return you generate, it creates a lot more discipline to sell when you think the time is right.”

Office Fundamentals Cloud Picture

Most property owners have had no problem figuring out when to sell given the roiling demand for real estate over the last couple of years. In 2004, office buyers and sellers completed 2,200 transactions valued at $53 billion, according to New York-based real estate research firm Reis, which tracks deals of $2 million and higher in 80 markets. To put those figures in perspective, the number of transactions rose 22% over 2003 while the total dollar value of transactions spiked 32.5%.

Meanwhile, the average office value in the top 50 U.S. markets climbed 3.3%, to $139 a sq. ft., from the third quarter to the fourth quarter of 2004, according to Reis. But buyers paid an average of $171 a sq. ft. during fourth quarter of 2004, or a 23.4% premium above the average value.

The rampant trading of office buildings resembles a game of musical chairs: As soon as investors sell, they must reinvest the proceeds somewhere — and much of the time they plow the cash back into real estate. But investors may eventually get stuck holding under-performing office buildings when capital dries up, particularly with no clear sign that robust occupancy and rent growth is returning to most areas of the country.

“It's somewhat of a concerning situation because you're seeing all this money being driven into the markets,” says William Pollert, president of New York-based Capital Lease Funding, a net lease real estate investment trust (REIT). “So while investors should be dealing with fundamentals, demographics and location, it's easy to overlook them if they have shareholders saying, ‘I gave you $100 million; why do you still have it?’”

Still, investors are taking the inklings of a recovery to heart. National average vacancy, which peaked at 16.9% in the first quarter of 2004, dropped to 16.2% in the fourth quarter, according to Reis. About 700,000 new office jobs were created in 2004, which helped generate absorption of 40.8 million sq. ft. for the year. That marked the first time in three years that office users moved into more space than they abandoned; in 2003, for example, negative absorption was 8.5 million sq. ft., according to Reis.

Experts project that anywhere from 400,000 to 700,000 new office jobs will be created in 2005, which could translate into absorption of 60 million sq ft. to 80 million sq. ft. But mergers between companies such as Sprint Corp. and Nextel Communications, and AT&T and SBC Communications, likely will result in tens of thousands of job cuts and throw vacant space on the market. Moreover, uncertainty hangs over the general economy: inflation, interest rates and the federal deficit.

Thus, it could be a good two or three years before many markets see large occupancy gains, suggests Nicholas Buss, senior vice president and group manager for real estate market research and valuation at PNC Real Estate Finance in Pittsburgh. “What we saw last year was that the office job growth backfilled shadow space,” he says. “I think we'll see similar office job growth this year, and it should move the vacancy figure down a little further.”

Don't Hesitate to Liquidate

Some investors aren't prepared to wait. Last spring, National Office put 12 properties totaling 6.4 million sq. ft. on the market. The last few remaining sales were completed in January, and the entire pool sold for $2.2 billion, which generated an annual rate of return of 12.5%, according to MacEachron.

But while the prices National Office fetched for the assets met or exceeded the partnership's optimistic expectations, not every sale made money. In January, for example, National Office lost some $38 million on the 668,000 sq. ft. Riverfront Office Park in Cambridge, Mass., which it sold to RREEF for $175 million. National Office went ahead with a few money-losing sales out of the bunch, MacEachron says, after the partnership determined that it could miss out on the frothy capital markets while waiting for the fundamentals in some markets to improve.

“When you have 15% or 20% vacancy in a market, you can begin to have an increase in demand for space, but that doesn't translate immediately into higher rents,” says MacEachron, who also is the portfolio manager for National Office. “Speaking broadly about many markets, I think it's fair to say that no one is feeling super confident that there's going to be strong, steady improvement in the underlying fundamentals.”

On the other end of the scale, National Office realized a gross profit of $87 million from the sale of the 343,000 sq. ft. 1900 K Street in Washington, D.C. New York-based TIAA-CREF acquired the building in December for about $353 million.

Nearing the Finish Line?

Real estate experts wonder how long the market can sustain the lucrative profit-taking, particularly as buyers continue to bid up prices. Indeed, major markets have seen a rash of sales that have either set new price records — or have come close to it. In December, TIAA-CREF acquired National Office's 3-year-old IDX Tower in Seattle for $368.6 million. At $411 per sq. ft., that was a record. Trizec's $435 million purchase of Bank of America Plaza? At about $310 per sq. ft.: a record for Los Angeles.

Investors insist that prices are still below replacement cost, given the general price increases of steel, lumber and other commodities last year. In January, Beacon Capital purchased the 970,000 sq. ft. Bay Colony Corporate Center in Waltham, Mass., from Shorenstein for $274 million. At $280 per sq. ft., the price was thought to be a record in the suburban market, but the four building office park on 58 acres would cost upwards of $300 per sq. ft. to build today.

Additionally, Beacon Capital beat out four competitors for the Bay Colony property. The bidding wars likely won't end anytime soon. Why? The often-repeated reason is that more attractive investment alternatives to real estate simply don't exist.

But given the extraordinary amount of capital chasing deals, which is pushing down capitalization rates, the property markets may be losing some of the sheen they had three years ago, says Beacon Capital's Leventhal. “Real estate is still attractive,” he says, “but there's not as much of a disparity between real estate and other asset classes as there once was.”

Bent on Acquisitions

That's not slowing down investors. National Office, for example, anticipates having an investment capacity of $1.5 billion in 2005 and plans to aggressively seek new acquisitions and development opportunities, according to MacEachron.

Meanwhile, CommonWealth Partners of Los Angeles has more than $1 billion available for office acquisitions next year via its Fifth Street Properties fund, which is a partnership between CommonWealth, CalPERS, and New York-based Rockefeller Group International. But CommonWealth is taking advantage of the demand for real estate, too.

In late January, the real estate investment firm agreed to sell 5 million sq. ft. and four development sites within the Fifth Street portfolio for $1.5 billion to Maguire Properties, a Los Angeles-based REIT that owns 10 million sq. ft. of office space in southern California. While CommonWealth held the assets slated for disposition for an average of six years, it acquired one of the buildings, the 1 million sq. ft. 777 Tower in downtown Los Angeles, in July.

The pressure building in major markets, however, is beginning to send investors to secondary markets to search for opportunities, say experts. While smaller markets in the U.S. may offer investors better capitalization rates — 8.5% rather compared with 7% or less in major cities — that potential bump up in yield is in markets where occupancy and rent improvements have failed to keep up with the major cities, says PNC Real Estate Finance's Buss. The danger: Investors may find themselves stuck with illiquid assets if the fundamentals fail to improve as fast as hoped.

“We're seeing investors building the recovery into the price of assets and taking more leasing risk in smaller markets,” he says. “But it's a lot easier to get into those markets than it is to get out.”

Joe Gose is a Kansas City-based writer

Seller Building Location Months Held Price (millions) Profit/Loss (millions) Buyer
Beacon Capital Partners Bank of America Tower Los Angeles 24 $435 $165.80 Trizec Properties
Walton Street Capital Merrill Lynch Financial Center New York 22 $353 $87.20 Equity Office Properties Trust
National Office Partners 1900 K St. Washington, D.C. 49 $219.5* $87.00 TIAA-CREF
SL Green Realty Corp. One Park Avenue New York 39 $318 $84.50 Credit Suisse First Boston**
National Office Partners 50 Fremont St. San Francisco 53 $335* $75 TIAA-CREF
Xilinx 2310-2314 N. First St. San Jose, Calif. 43 $33.80 ($41.20) Santa Clara County
Charles Schwab Charles Schwab Headquarters San Francisco 46 $136 ($39.30) American Financial Realty Trust
National Office Partners Riverfront Office Park Cambridge, Mass. 51 $175* ($38) RREEF
National Office Partners Stonebridge Corporate Plaza Pleasanton, Calif. 46 $120* ($21.20) TIAA-CREF
SSR Realty Advisors Boston Stock Exchange Boston 47 $19.5 ($7.7) Oasis Development Enterprises
* Approximate or Estimate
** Joint Venture Interest
Source: Real Capital Analytics, NREI

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