Questioning The Coastal Deal Frenzy

It’s an article of faith among many office investors that pronounced economic growth is confined to markets like New York City and Los Angeles. Core properties near an ocean have routinely fetched higher prices than their landlocked peers. Rental growth and occupancy have also been healthier along the coasts, where a scarcity of land and exorbitantly high building costs tends to tamp down new supply.

But some investors have lost their faith in the perpetual upside of these coastal markets. Zaya Younan, 43, who founded Los Angeles-based Younan Properties in 2002, is putting his money elsewhere. Lofty sales prices, tiny yields and what he calls a “pack mentality” convinced him to look inland for better opportunities.

“It’s amazing that the big institutions and the REITs are making so many huge mistakes right now,” says Zaya Younan, a self-described “maverick” investor who worked as an engineer before raising the initial funds for his real estate business in 2002. Younan began targeting major Midwestern office markets such as Denver, Chicago and Dallas in 2002. But his buying campaign has intensified in recent months, making him one of Dallas’ largest landlords by square feet owned. “We buy assets where the upside potential is much higher than on the coasts. Plus, investors are paying too much for these coastal properties right now, which will be a problem for them in the future.”

Younan sold one Los Angeles office building in June for $50.5 million. He claims that Sepulveda Center, which he acquired for $27.5 million in 2004, generated an annual internal rate of return (IRR) of 125% — and a total return of more than 300% on invested capital in less than three years. Younan says he had 28 offers on the 173,727 sq. ft. Class-A office property before selling it for several million dollars more than he expected.

If Younan is right, many of the biggest real estate investors in the United States are wrong. The flight of capital into coastal markets has been well documented, bringing with it record prices and deal volume. But it may not be an “either/or” proposition, says one commercial real estate observer who endorses both strategies.

“It’s not such a bad plan, to be selling on the coasts and buying in the Midwest,” says Bob Bach, national director or market research at Grubb & Ellis. “But the coastal markets will also see plenty of job growth over the next few years so [investors] would likely want exposure to both markets.”

Consider: The Chicago office market posted 3.3 million sq. ft. of positive absorption during the first six months of this year — and that leads the nation. Dallas ranked second on that list, followed by Houston and Denver not much farther down the line. As Bach puts it, many interior markets “were late to this party” but are now enjoying the benefits of a widespread office recovery.”

It’s certainly cheaper to hunt deals away from the coast. In places like Manhattan and Los Angeles, where a global pool of capital is competing for deals, average capitalization rates fell below 7% last month, reports Manhattan-based Real Capital Analytics. And prices for trophy properties have produced yields far below the average. Manhattan’s 200 Park Ave. (the MetLife Building) fetched $1.72 billion last year, yielding less than 4%, according to the seller’s agent. Equity Office Properties Trust (NYSE: EOP) shelled out half a billion dollars for an 80% stake in Midtown Manhattan office tower, 1095 Avenue of the Americas. Local brokers pegged the yield on that partial acquisition at roughly 5.5%, which is about average for a Midtown Manhattan office property.

“There’s such an abundance of capital coming into these coastal markets,” says David Cobb, president and CEO of Los Angeles-based private real estate investment firm Bentley Forbes. “What you have is great demand meeting limited supply, but in many [interior] markets it’s often a different story.”

Higher yields aren’t the only reason that Younan is targeting markets such as Denver, Chicago and Dallas. According to the Dept. of Labor, Dallas and Chicago both generated more jobs last year than Los Angeles. Younan expects these cities to outpace the coastal cities in job growth over the next few years and predicts that more companies will relocate staff from expensive coastal cities to cities such as Dallas and Denver.

The only wildcard is new supply. Depending on whom you ask, Chicago’s inner loop district is drowning in new office supply as a similarly large pipeline is being developed in its suburbs. And Dallas may be the one U.S. office market that’s practically always overbuilt. But on the macro level, new supply doesn’t appear to be a problem for the national office market: Reis economist Sam Chandan says that completions remain muted. In fact, the total completions during 2006 through 2009 are expected to be less than half the 2001 total.

“We buy these assets at half their replacement cost, so we’re not really worried about new construction competing against us for tenants,” says Younan.

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