Experts Question Investor Appetite for Secondary Office Markets

Experts Question Investor Appetite for Secondary Office Markets

Office investors have finally begun to show caution after a string of strong quarters characterized by high demand and outstanding property fundamentals. But experts disagree about whether this will put the focus this year on assets in primary or secondary markets.

There’s been no blip in demand so far—rather, it’s getting harder to find great deals in top markets. Investment in office properties in primary markets took a dip in the first quarter, as investors got spooked by watching yields shrink in high demand areas. According to a recent office outlook report from real estate services firm JLL, large portfolio sales in secondary markets, combined with a lack of development, pushed transaction volumes to 37.0 percent of the total market in the first quarter, at $7.6 billion. Quarter-over-quarter, primary markets accounted for an overall moderation in volume growth, while secondary markets recorded a modest increase.

Investors moved into secondary U.S. office markets due to rising political and global tension, financial turmoil in China and, of course, prices getting out-of-reach in the top central business districts (CBDs), says Steve Collins, head of JLL’s capital advisors group.

“They are realizing it’s better to spread it around,” he says. “The same credit that they put into New York might see a 300-point basis point difference in yield in a market such as Charlotte or Atlanta.”

Other experts agree. The breadth of the U.S. office market is one of its greatest strengths, as having options, such as “pocket markets” and mixed-use developments, provides value, according to Aegon Asset Management’s first quarter overview report.

“Secondary office markets are experiencing higher levels of investment for just this reason, somewhat greater volatility priced by higher yields, and the ability to accommodate fast-growing companies with a volume of new construction, at costs much lower than that available in the primary downtowns,” according to the Aegon report.

One reason for the sales volume drop in primary markets, according to Collins, is that foreign investors typically play a large role in the big market deals. If those deals dry up, some of the available capital also becomes unavailable, he says. German and British investors, and the main sovereign funds, are comfortable, and many have local offices in the primary markets and are exploring the secondary regions. The smaller funds and Chinese investors are mostly working to create relationships, he says, and typically are still partnering with local firms.

“Some of the foreign groups, you can’t be shy with them, they don’t respond to the typical American teaser ad, you have to initiate direct contact,” Collins says.

Also, coming out in the secondary markets’ favor were a couple of large portfolios deals. Blackstone’s acquisition of BioMed Realty Trust accounted for an office and laboratory portfolio of about $4.8 billion, and Och-Ziff Capital Management purchased 58 properties of suburban product from Brandwine Realty Trust for almost $400 million, totaling about 3.9 million sq. ft. of East Coast property from New Jersey to Virginia.

Another report, by PGIM Real Estate, however, claims that while there is appetite for the secondary markets by investors seeking higher returns, and there is $230 billion of capital waiting to be deployed into commercial real estate, most investment, including foreign capital, is still concentrating on the primary U.S. markets. As property fundamentals in 2016 haven’t improved as much as they did last year, and there’s threat of further interest rate hikes, PGIM researchers say that investors and lenders remain reluctant to commit capital to riskier investment strategies.

“Over the past year, the share of capital being directed towards major cities has risen, despite broadening economic growth and a steadily increasing set of markets reporting rental growth,” according to the PGIM report. Not only do cities like New York offer proven liquidity, they also bounced back earlier and stronger following the global financial crisis, seeing office rent increases almost double that of secondary markets.

“Owing to a perception that downside risks are rising, real estate investors and lenders remain nervous and reluctant to commit capital to riskier investment strategies, maintaining a bias for sticking to major markets rather than expanding their horizons,” according to the report, which was overseen by Peter Hayes, global head of investment research for PGIM.

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