Office Investment Risks Mount

Office landlords can't help but smile. The national vacancy rate has declined for 11 straight quarters, registering 13.1% at the end of March. Manhattan-based real estate research firm Reis also reports that average asking rents have been trending upwards, rising from $25.06 to $26.70 per sq. ft. over the 12-month period ending in March.

The healthy state of the market is a stark contrast from the 18.3% vacancy rate recorded in June 2003, when the office sector bottomed out. But after a long successful run, Reis chief economist Dr. Sam Chandan believes that office market momentum is starting to weaken.

“There are definitely some warning signs for office fundamentals,” says Chandan. “Slower job growth in particular is already translating into weaker net absorption, and the big rent gains are concentrated in just a few markets,” he says. Monthly job growth in the U.S. averaged 129,000 during the first four months of this year, down from an average of 189,000 during the same period in 2006.

Power players

Economic growth weakened during the first quarter. Gross domestic product (GDP) registered just 0.6% for the quarter, which was below Wall Street estimates. Full-year GDP for 2006 was 3.3%, edging up from 3.2% in 2005. Economists expect the economy to grow 2.6% in 2007.

Chandan says that large cities such as New York and San Francisco are hubs for job creation. And that growth is buoying their already-tight office markets. Average effective office rents in New York jumped by 6.5% during the first quarter on the heels of an 18.3% increase last year. In San Francisco, average effective rents popped by 8.9% during the first quarter.

Expect that growth to linger, too. Chandan projects that average annual rent growth over the next four years will hit 7.3% and 7.0% respectively in both office markets. By comparison, average rental growth for the 64 largest metro markets should only hit 5% during that period. “If you exclude these two metros from the calculation, the national effective rent increase in the first quarter falls from 2.8% to 1.9%,” adds the economist.

Chandan expects the latter half of 2007 to bring more economic weakness. The upshot for office investors is that effective rent gains will likely slow down over the next few years (see chart).

Despite signs of weakening fundamentals, hordes of deep-pocketed private equity funds and institutional investors are on the prowl for single-asset and portfolio deals. In late May, Morgan Stanley gobbled up office REIT Crescent Real Estate Equities for $6.5 billion. That deal pales in comparison to the Blackstone Group's record purchase of Equity Office Properties Trust earlier this year for $36 billion, including assumed debt.

Single-asset deals also are fetching record prices. In March, 666 Fifth Avenue in Manhattan fetched $1.8 billion, or $1,200 per sq. ft. The buyer of that tower, private real estate firm Kushner Cos., generated a 3.5% cap rate on that deal.

Edge cities

Demand for trophy assets in major cities remains strong, but suburban markets will offer the best earnings growth going forward, says Mitchell Hersh, CEO of Mack-Cali Realty Corp. Mack-Cali ranked 10th in NREI's latest ranking of the largest office owners with a 33.9 million sq. ft. portfolio as of Dec. 31, 2006.

“The suburban markets have really lagged behind the urban centers in recent years,” says Hersh, who owns and operates New Jersey's largest office portfolio of largely suburban office space. The company recently spent $273 million to buy lower Manhattan office building 125 Broad Street.

“Occupancy costs are lower in the suburban markets, and more companies are tapping the labor force that's increasingly moving into these areas,” says Hersh. The average asking rent for suburban office space nationally was $27.41 per sq. ft. during the first quarter compared with $44.82 per sq. ft. in the central business district, reports Grubb & Ellis.

Mack-Cali has seized on corporate demand for suburban office space. In 2006, Mack-Cali spent $545 million to buy a 2.8 million sq. ft. office portfolio in New Jersey. Most of the properties that were owned by Gale Real Estate Services are low-rise suburban office buildings.

Selecting the right suburban market is critical because speculative office construction is running rampant. Approximately 75 million sq. ft. of speculative suburban office space was under development at the end of March, six times the volume of speculative construction in the CBD, reports Grubb & Ellis. It was also the biggest pipeline of speculative suburban office supply since mid-year 2001.

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