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The good times have been rolling along in the office investment sales market. An ample supply of equity and debt has fueled a steady level of sales activity over the past year, and many expect that momentum to continue in the first half of 2019.

“Even though we might be near the end of the cycle, or at least having a leveling off in our cycle, globally there is a ton of money still searching for a home,” says Rebecca Wells, CCIM, senior vice president of investment sales at Lee & Associates in Indianapolis. Despite signs that occupancy and rent growth may be slowing, buyers are exhibiting a healthy appetite to acquire office properties. Sales for 2018 (excluding entity-level transactions) dipped 3.1 percent compared to $130.3 billion in 2017, according to Real Capital Analytics.

Transaction volume was spurred by what continues to be a very liquid market. At the beginning of December 2018, the amount of investable capital, also known as dry powder, held by global private equity real estate funds reached a record high of $295 billion, according to Preqin, a London-based research firm specializing in supplying data and analysis to the alternative assets industry. Most of that capital remains firmly targeted at the U.S., where global investors see a haven for real estate investment. Institutions are maintaining, if not increasing, allocations to real estate, and many expect the creation of opportunity zones to fuel more sales activity. “We have not seen any pullback, and even smaller investors want to place money somewhere and lock in historically low interest rates while they can,” Wells says.

The big question is where that capital will be flowing in a maturing market cycle where opportunities for rapid appreciation are disappearing and occupancy and rent growth are slowing. Investors also are cognizant of transformational changes ahead that are likely to impact future office investment, such as new technologies and growing demand for coworking space, Wells says. “We are seeing investors that are being very careful with their exit strategy, upside potential, and anything that could transform the market for them in the coming year,” she says.

Investment strategies run the full spectrum, with capital available for more stable core and core-plus assets to riskier value-add and opportunistic properties in both urban and suburban markets. Some investors, however, are tweaking acquisition criteria to account for slowing growth. The office market has struggled with a tepid post-recession recovery over the past several years and is bracing for a further slowdown. Office vacancies are expected to tick slightly higher to 13.2 percent in 2019 and 13.6 percent in 2020, according to the ULI Fall 2018 Real Estate and Economic Forecast, while rent growth will slow to 2 percent this year and  1 percent in 2020.

Middleton Partners is one investment group that is adopting a more conservative strategy to fit changing market conditions. “As the market cycle has matured, we have become focused less on lease rollover risk and more on predictable income stream,” says Mark Cypert, CCIM, a partner at Middleton Partners, a Chicago-based private equity investment group. The firm has shifted from value-add investing several years ago to focusing on acquiring institutional-quality assets with a core or core-plus profile in markets that have favorable employment growth.

Middleton is looking at buying opportunities nationally, especially in the Midwest and pockets of the Mid-Atlantic. However, Cypert also says that finding deals with attractive returns on investment is increasingly difficult, given competition and cap rate compression. “I will look at 1,000 deals to find one that works,” he says. “We’re casting a pretty wide net, and the opportunities at this stage of the cycle are fewer and farther between, but we’re still searching.” For example, the firm has bid on deals recently in Milwaukee and Fort Myers, Fla.

Capital Continues to Target Secondaries

The search for higher yields has fueled buying activity in secondary cities for the past few years, and money is still focused on non-gateway markets. However, investors are more selective in identifying opportunities in those smaller metros.  Buyers generally are looking for markets that still have steady rent growth, while avoiding those where rent growth is expected to be flat, notes Paul Waters, CCIM, chief operations officer at Integra Realty Resources in New York City. For example, Integra has identified a top 10 list of bullish office investment markets in 2019 based on criteria that includes a level pattern of rental rate growth and low variance in rents across submarkets. Aside from Manhattan  and Chicago, that list comprises secondary markets that include Broward County, Fla.; Jacksonville, Fla.;  Las Vegas; Phoenix; Denver; Raleigh/Durham, N.C.; Nashville, Tenn.; and Minneapolis.

Many secondary markets are seeing big inflows from national and regional capital sources, including many new entrants. For example, Memphis, Tenn., has seen a spike in interest from outside capital over the past four years. In fact, almost all the significant office sales in the past year have gone to buyers from Nashville, out-of-state parties, or international investment groups from Canada and Israel. “Cap rates have become so compressed in a lot of the coastal markets, and even our neighboring city Nashville, that Memphis presents an opportunity to acquire assets at a good cap rate,” says Landon Williams, CCIM, SIOR, senior vice president of capital markets at Cushman & Wakefield in Memphis.

Most outside capital coming into Memphis has focused on the city’s urban core, but investors are looking for opportunities that still have some meat on the bone, Williams says. Strategies vary depending on the investor, but they generally want to buy assets that have some upside to improve occupancies by making changes ranging from minor cosmetic improvements to more extensive renovation and repositioning. Some buyers want to acquire a Class C or B building in a Class A location where they can make improvements, such as renovating the common areas or upgrading elevators, to raise the status of the building to a Class B or B+, Williams says.

“We’re pretty far into the current economic cycle. Many of the core properties are priced to perfection,” Wells adds. “Most investors realize where we are in the cycle, and they are looking for more of a story.” That doesn’t necessarily mean a full value-add, but they are looking for upside with leasing potential, below-market rents, or needed property improvements, she says.

For example, a joint venture about 18 months ago between Rubenstein Partners and Strategic Capital Partners acquired Precedent Office Park in Indianapolis for $132.7 million. The new ownership quickly announced plans for major capital improvements at the park, which includes nearly 1 million sf of Class A office space in multiple buildings surrounding a 38-acre lake. Owners have since rebranded the property as Lakefront at Keystone, with several new amenities set to open this summer, including walking paths, fitness and conference facilities, and an outdoor lakefront lounge.

Suburbs Offer Higher Yields

Given the broader trend of urbanization sweeping the country, institutional capital is exhibiting a preference for central business district assets. Yet investors are finding more attractive yields in the suburbs. As of 4Q 2018, suburban cap rates were averaging 6.8 percent versus 5.2 percent for CBD assets, according to RCA. However, investors also are more selective when buying in the suburbs, often avoiding outliers and instead choosing suburban assets in an attractive location with sustained demand and good transit infrastructure and amenities.

For example, the Omaha, Neb., market has seen capital flowing to suburban office over the past year. “We are a small enough market that I don’t think you can extrapolate a trend between suburban and CBD office, but office investment in general is definitely up in the past few years,” says Ember Grummons, CCIM, an investment sales broker at Investors Realty in Omaha. Interest in and pricing for suburban multitenant office buildings continue to increase, he adds.

For example, Grummons represented the seller in the sale of North Park Buildings 7 and 8, located just west of Omaha’s I-680 loop, in a sale that closed last June for $22.3 million, or $126 per sf. The neighboring buildings, North Park Buildings 4 and 5, sold in early 2017. The more recent sale garnered a cap rate almost 200 basis points lower and a price per square foot that was 22 percent higher.

The 10-year Treasury rose approximately 50 basis points during the period between the two transactions, making the comparison between the two sales even more dramatic, Grummons notes. “I believe the improved pricing is due to a combination of factors – increased buyer demand for multitenant office, improving fundamentals in North Park, and the dramatic increase in the costs of new construction, which makes the cost per square foot of existing property look attractive in comparison,” he says.

The suburban markets around Dallas-Fort Worth continue to be a seller’s market for smaller office and medical office properties. “Right now, there is a ton of 1031 money, and a ton of brokers are scratching and clawing to get off-market listings because the inventory of investment properties in Dallas-Fort Worth is so thin that it’s hard to find properties to buy,” says Russ Webb, CCIM, owner and managing partner at Silver Oak Commercial Realty in Southlake, Texas.

Cap rates are still very low, even with interest rates going up, Webb says. “We’re seeing mom-and-pop medical office building owners selling properties at 7.0 to 7.5 percent on triple net leases with local credit tenants.” Some owners are reluctant to sell, though, because they don’t have anything to exchange their property into, he adds.

One reason that investors have kept their foot on the gas for acquisitions is that even with some softening in fundamentals, the outlook for office is still positive. “The office market cycle is in the late expansion phase and possibly near the peak, but I do see demand growth – at least for the foreseeable future – for office using employment,” Cypert says. Cap rates are likely at or near the bottom in most markets. However, investors remain fairly bullish on the office investment market, even if that means being mindful of potential risks ahead and working harder to find good investments.

Investors Tackle New Underwriting Challenges

Investors are acquiring office assets even as they face a flurry of challenges forcing them to sharpen their underwriting skills, such as soaring construction costs, disruptive technologies, and expansion of coworking.

Explosive growth in coworking and flexible workspace is front and center for office investors. For the past three years, the U.S. has added more than 5 million square feet of coworking space annually, according to Cushman & Wakefield. The firm estimates that the flexible space market currently represents 1 percent of the total multitenant market, with the potential to grow to between 5 and 10 percent in the future.

“I believe the coworking trend will be transformative for the office market,” says Rebecca Wells, CCIM, senior vice president of investment sales at Lee & Associates in Indianapolis. The metro area is home to 14 different coworking providers that are leasing space, or in the case of Novel Coworking, purchasing their own buildings. The office is where people spend most of their time, and people want to make that part of their day more interactive. Coworking also allows for greater flexibility on the part of the tenants who might be unsure of their expansion or contraction needs in the short term.

Nationally, landlords and real estate service firms also are moving into coworking. Brookfield and RXR Realty have partnered with Convene to design and service flexible workspace at properties, with initial projects up and running in Los Angeles and New York City. CBRE also launched its own flexible workspace subsidiary, Hana, in early 2019 to provide flexible workspace consulting services to both landlords and tenants.

“Coworking and flexible space is clearly a trend that we see continuing going forward,” says Mark Cypert, CCIM, a partner at Chicago-based Middleton Partners, a private equity investment group. Investors are keeping that trend in mind with an aim to build out spaces that are coworking- friendly with open, flexible floor plans and building amenities that will help to attract tenants — whether that is employers or coworking space providers. In addition, the general trend is to pack in more people per square foot, which affects everything from parking density and floor plans to capacity for elevators and restrooms. “When we do forecasting for future demand, we take those fundamental changes into account,” Cypert says.

Upgrading Class B Properties

Another challenge for investors is the transformation occurring within the Class B office market. Some Class B property owners are spending more money to attract big tenants, which in some cases, is resulting in retrofitted B buildings that are on par with some Class A towers, says Paul Waters, CCIM, chief operations officer at Integra Realty Resources in New York City. High-profile examples of that include General Electric in Boston and Google and Amazon in New York City. Those upgrades are creating new underwriting challenges for investors looking to buy those upgraded Class B assets. “The variance between some A Class and B Class space is really making investors sharpen their pencils quite a bit,” he says.

For example, is a Class B retrofitted building in Manhattan now a better return on investment than a Class A tower? It might be, and that certainly wasn’t the case 10 years ago, Waters says. In addition, investors buying Class B buildings are, in some cases, looking at spending the same money on fit-out of tenant spaces that is more typical of a Class A building. Investors must carefully analyze whether they can achieve the rents necessary to justify those higher investments in building improvements — especially amid soaring construction costs. “It is very challenging for some investors because the increased fit-up dollars are changing the profile of everything,” Waters says.

Trends in Office Volume & Pricing

This article was originally written & published by Beth Mattson-Teig in CIRE Magazine March.April.19 Edition.