Best Places for Commercial Real Estate Investments: Office Sector

By David Lynn, Ph.D

Commentary November 24, 2014 at 07:22 AM

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Office markets are a bifurcated property sector in terms of subtype (Central Business District versus suburban) and geography (larger, first-tier markets versus smaller secondary markets). Generally speaking, newer, landmark, or trophy, Class A properties in the central city command the highest rents from higher-profile financial services, legal, and professional services firms, while the suburbs offer more space at somewhat lower rents per square foot for technology, telecommunications, and back-office operations.

Suburban markets have historically played second fiddle to the prestige of the Central Business District (CBD), competing with lower rents, but also with sprawling, low- to mid-rise buildings with campus-like facilities and a proximity to the suburban residential developments where many office workers traditionally live.

Considerable variation exists in the office market, from metropolitan area to metropolitan area, from city to city, and from city to suburb. Class A CBD office space in Denver may not compare directly to Class A in New York or Chicago. In the post-recession period, in particular, a significant "value gap" has emerged between the top tier urban centers and the rest of the country, and between those cities and the suburbs that surround them.

During the slowdown and recovery, risk-averse investors swarmed larger, prestigious markets like New York, Chicago, San Francisco, Los Angeles, Washington, DC, and Seattle, among a few others, bidding values higher, especially on core, investment-grade trophy and landmark properties, and squeezing yields to levels last seen in the early to mid-2000s.

Figure 2.5. Top 10 US Metropolitan Markets in 2013 Office Transactions

Rank, by Volume ($bil)	Market	Vol ($bil)	$/sf	Cap rate
1	NYC Metro	$27.51	$537	5.74%
2	LA Metro	$8.62	$293	6.48%
3	SF Metro	$6.95	$356	6.00%
4	DC Metro	$6.64	$382	6.46%
5	Chicago	$5.01	$188	7.64%
6	Houston	$4.77	$215	7.33%
7	Seattle	$4.69	$428	5.99%
8	Boston	$3.25	$254	6.42%
9	Dallas	$2.84	$154	7.46%
10	Atlanta	$2.82	$169	7.99%

(Source: Real Capital Analytics, Inc.)

It has only been in recent quarters that investors have been willing to accept some additional risk to achieve higher yields. And, it has only been in recent quarters that they have been able to access the capital they require to reenter smaller, riskier markets. That has brought new activity to a number of secondary markets, including Philadelphia, Denver, Austin, Texas, and Charlotte, North Carolina, where well-priced Class A properties have come into play.

Office Construction and Vacancy Declining

Additionally, there has been some "trickle out" through the marketplace into still riskier placements in the suburban office arena, and into some Class B and C properties, where some investors are making strategic value plays. In fact, Real Capital Analytics reports that, although suburban office properties remain in a bit of a value slump—pricing remains about 30 percent below a 2007 peak—transaction volume has surged in 2013, lifting suburban office values.

In some areas, suburban office transaction volume has exceeded CBD for the first time in years. Jones Lang LaSalle (JLL), a financial and professional services firm that specializes in commercial real estate services and investment management, estimates that suburban office accounted for more than 91 percent of absorption in 2013, with vacancies falling from 20.4 percent to 18.5 percent during the period. Over the past year or so, Class B and C properties—particularly those that can be renovated or retrofit to meet demand for Leadership in Energy & Environmental Design (LEED) certification—have begun to join the recovery in a number of markets, with rising demand for space that cannot be accommodated by what analysts at JLL call "thinning options" for Trophy and Class A product. JLL reports that Class B and Class C absorption had increased from just 2.2 million square feet in 2012 to more than 10 million square feet between mid-2012 to mid-2013.

Still, the overall vacancy rate has been slow to move down. After peaking at 17.6 percent overall (for both CBD and suburban space) in 2010, total vacancies remained at just over 17 percent at the end of 2012, according to Reis, Inc., a well-respected provider of commercial real estate market information and analysis. Much of that vacancy is still in suburban and older properties, with average vacancies in the 20 percent range, while the Class A vacancy, as of mid-2013, was estimated to be 16.6 percent by JLL. The strongest absorption has been noted in California and in Texas.

Until approximately mid-2013, there has been only marginal rent growth. After rapid and dramatic rent declines in 2009, which saw effective rents fall 8.9 percent, according to Reis Inc., and 2010, with an additional 1.5 percent drop, rents more or less stabilized in a 2 percent per year growth range in 2011 and 2012. The evidence of recovery in the office market might be found here: rent growth rose above 1.2 percent in the second quarter of 2013, according to JLL, and landlord concessions have pulled back by 4.7 percent.

Office Construction Trends (or Lack Thereof)

For the most part, with vacancies still high, and with tenants cramming more bodies into smaller spaces, significant new construction is not on the horizon in the near- to mid-term. New office completions fell from a high of more than sixty-five million square feet in 2008 to just twelve million square feet in 2012, according to Reis, Inc., even as numerous "functionally obsolete" office properties have been taken offline. Mid-2013 did see a small jump in new office construction, rising to around seven million square feet in the second quarter of 2013 from about two million square feet in the first quarter. Development has been noted in some of the more active major cities—Washington, DC, and New York, for instance—and most have been newer "green" and technologically advanced buildings. Still, even with only a few current projects underway in a few markets, office construction remains subdued overall.

In place of new construction, numerous renovations, retrofits, and upgrades have been noted, as owners work to attract tenants to their properties with enhanced efficiencies, reduced costs, and a lighter carbon footprint. The recently published Emerging Trends in Real Estate 2013, from PwC and ULI notes that "'hard-to-retrofit' (older) buildings, including some ten- and twenty-year-old vintage towers (could become) increasingly obsolete." Observant office building owners are always noting where renovation will boost the bottom line. In Chicago, the famous Rookery building—built in 1888 as one of the first skyscrapers—has been renovated three times, including once in the last five years. In addition, the Wrigley Building, built in 1924, was renovated with new infrastructure and flexible floor plates in 2013.

Technology and Demographics in Office Market

Office markets have undergone dramatic changes in recent years, as developments in technology and workforce demographics have driven the demand for, and the use of, office space. Ironically, this is not anything new. Office space has been evolving with technology and demographics from the time Burnham and Root and Louis Sullivan built their first "skyscrapers" in the Chicago Loop 125 years ago. It is a fact of life in the office market that change happens. The difference, today, is that change happens at an increasing rate. And, the nature and pace of change is important in the way we approach office markets going forward.

In the office environment, over time, we have transitioned from steno-pools and banks of typewriters, to teletypes, to faxes, to email and DocuSign®. Law libraries are today decorative, with the real research now managed through online databases, such as LexisNexis® or Westlaw, and other realms of the Internet. Filing cabinets—rooms and rooms of them—have been reduced to an online, virtual "cloud." Even telephones, at least the hard-wired, landline variety, are beginning to disappear—with one research study suggesting that up to 40 percent of knowledge workers will have abandoned their desk telephones by the end of 2013.

As employers confront these technological and demographic changes, they are recognizing enormous economic advantages to adjusting the office to meet them. With real estate costs second only to labor in the overall cost of doing business, employers are recreating the office to utilize the space more efficiently and to reduce the amount of floor space required per employee. One estimate, from Jones Lang LaSalle, suggests that traditional office employers could release as much as 30 percent of their space, with a national average, among all industries and geographies, of about 15 percent. The JLL study points out that office space requirements have shrunk from an estimated 500 to 700 square feet per employee in the 1970s to a little more than 200 square feet in 2010, and the study projects that the per-employee space allocation could slide to an average of just 50 square feet by 2015.

Although the decline in office space requirements has been underway for several decades, the recent recession helped building owners and their tenants see the light as they redesigned old floor plans to speed productivity, attract young talent, and cut costs. As a result, many major office-leasing employers are cutting back on floor space—even entire floors—while maintaining staffing at essential levels. It is interesting to note that, in some high-value urban centers, such as New York for instance, some older office properties in less than Class A locations are commanding higher rents, as employers—especially technology firms—take up space that is considered nontraditional and "hip."

Tapping into the tech-savvy, urban-dwelling, Millennial generation, a number of tech firms are paying rents that exceed those being paid in many trophy buildings in Midtown and Lower Manhattan. The natural consequence is that traditional landlords are carrying the burden of leasing now-empty space and of offering new tenants the flexibility they require.

What Office Investors Are Looking at and Where

Investors continue to view high quality Class A properties in gateway urban centers—24-hour cities—as highly attractive for an office portfolio. For the most part, these are in the larger metropolitan areas in the country with well-developed office markets in the CBD, in quality suburban areas (e.g., Irving, TX; Denver's Tech Center; Belleview, WA), or both, that have demonstrated relatively good population and job growth dynamics. Many of the jobs that are created in those cities are tied to technology (still a job creation machine), energy, and banking. Employment growth in the San Francisco area (San Francisco and San Mateo counties) outpaced the nation last year, for instance, with job gains exceeding 4 percent. San Francisco is among the top tier of cities in which a solid mix of job-creating industries is concentrated.

Other Pacific Coast cities, including Seattle and Portland, also exhibit high concentrations of job-creating industries, driven in large part by technology. As a recent Forbes article by Joel Kotkin and Mark Schillreminds us, "no place on the planet can boast so many top-line tech firms: Amazon and Microsoft in the Seattle area, and in the Bay Area, Intel, Apple, Facebook and Google, among others." Other metropolitan areas, including Washington, DC, with its still-substantial government employment base (despite sequester) and growing financial services and technology sectors, and Houston, with its enormous energy sector and export machine, promise to be near the top of any list for investment—and not just in the office sector.

Figure 2.7. 20 Best Large Cities (Population over 450,000) for Job Growth in 2013

2013 Rank	Area	2012 Employment (1000s)	2012 Size Rank
1	San Francisco-San Mateo-Redwood City, CA Metropolitan Division	1016.2	17
2	Nashville-Davidson-Murfreesboro-Franklin, TN	802.5	9
3	Salt Lake City, UT	656.3	3
4	Fort Worth-Arlington, TX Metropolitan Division	915.0	4
5	Houston-Sugar Land-Baytown, TX	2740.8	2
6	Dallas-Plano-Irving, TX Metropolitan Division	2156.0	6
7	San Jose-Sunnyvale-Santa Clara, CA	918.5	5
8	Charlotte-Gastonia-Rock Hill, NC-SC	865.8	19
9	Denver-Aurora-Broomfield, CO	1258.2	15
10	Austin-Round Rock-San Marcos, TX	837.9	1
11	Raleigh-Cary, NC	526.6	7
12	San Antonio-New Braunfels, TX	883.8	20
13	Columbus, OH	957.3	22
14	Seattle-Bellevue-Everett, WA Metropolitan Division	1459.5	14
15	Oklahoma City, OK	600.0	10
16	Indianapolis-Carmel, IN	918.6	32
17	Boston-Cambridge-Quincy, MA NECTA Division	1745.5	29
18	New York, NY	3908.8	11
19	Northern Virginia, VA	1364.8	12
20	Louisville-Jefferson County, KY-IN	618.5	25
(Source: Joel Kotkin; Praxis Strategy Group)

A number of advisory firms (Jones Lang LaSalle, Integra Realty Resources, and Dividend Capital, for instance) regularly offer their take on commercial property performance and where various geographic markets stand in the real estate cycle for the several property segments. Recent releases are remarkably similar in their view of recovering, expanding or slowing and declining markets. Generally speaking, Office, both CBD and suburban, is viewed as being in the very early stages of recovery, with occupancies still below long term averages and rent growth still at or below inflation. Strong CBD markets with asking rents rising more than 1.5 percent in the second quarter of 2013 (according to JLL) include, especially, New York, San Francisco, Los Angeles, Seattle. Strong suburban markets with rent gains of about 1 percent during the most recent period include the San Francisco MSA, Seattle, Austin and Denver.

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