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Going Coastal: Real Estate Capital Hugs The Shore

Sam Zell launched his storied real estate career in Michigan, flipping apartment buildings in the 1960s. Since then, Chicago-based Zell has bought and more recently sold scores of office buildings in secondary markets. While his latest dispositions have coincided with a strong seller’s market, Zell has publicly voiced larger concerns about the future of secondary real estate markets.

“Some major changes are taking place in society,” said Zell, chairman and CEO of Equity Office Properties Trust, addressing a New York University-sponsored REIT conference in Manhattan last month. “And these changes are translating into a series of dynamic, 24/7 cities. That’s where the workforce is going, and that’s where it will continue to be because people won’t gravitate as much to secondary cities.” He identified Des Moines as one such city.

Zell is taking his own advice to heart. In November 2004, Equity Office sold off its five-building Houston portfolio, which accounted for 2.2% of the entire national portfolio. That same month, the firm also parted with 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. Earlier this month, for example, Equity Office closed on midtown Manhattan’s Verizon building for $563 million. Equity Office isn’t alone, as other REITs have increasingly sold off midwestern 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 — compared with $4.4 billion in 2003.

With some minor exceptions, investor confidence in coastal markets is validated by the fundamentals. Grubb & Ellis shows that the steepest vacancy declines between year-end 2002 and 2004 occurred in coastal markets. Palm Beach County, Fla., office vacancy dropped 620 basis points, from 17.3% to 11.1% over that period. Orange County, Calif., meanwhile, came in second with a 490-basis point decline from 16.4% to 11.9% over that period. 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.

Demographics shed some light on why investor dollars are pooling along the coast. For one thing, 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. New York is both a global center of culture and finance. Meanwhile, the cities along the southern California coast rely on entertainment, defense and biotechnology firms to keep their local economies humming.

These markets are also better equipped to capture commodity jobs. That didn’t matter a whole lot a decade ago, but that was before Manila and Mumbai were siphoning off Iowa call center jobs. “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, below]. 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. The one thing that has changed, says Pierson, is the capital markets, which 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.”

The Midwest was the only U.S. region to see the average price per sq. ft. of its office space fall over the past two years.

Regional Office Market Price Per Sq. Ft.

Regions 2003 2004
Midwest $131 $119
Mid-Atlantic $177 $187
Northeast $234 $242
Northeast $234 $242
Southeast $115 $127
West $171 $200
Source: Real Capital Analytics
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