Saturday, September 18, 2010

Prime Office Real Estate

Institutional interest in prime office buildings has been strong since the end of last year. This is not surprising: cap rates (annual lease rates ÷ capital costs) are high, while the yield on competing investments in quality corporate bonds is hardly compelling. There is a widespread perception that prime locations can be picked up at distressed prices, offering the prospect of capital gain in addition to a solid income stream. Vacancy rates in most markets, while elevated, are not extreme, and there is little supply coming on stream from new construction in most of them, suggesting that lease rates will remain firm provided that vacancies do not rise. There are reasonable grounds for confidence that they will not, if only because they have failed to do so during the worst of the recession: lessees are either warehousing space for future needs or using space less intensively than they had in recent years. Finally, the inflation-protective aspect of real estate is attracting institutions that require current income (such as those with distribution requirements), since they are otherwise challenged to find such protection from income-producing instruments other than TIPS.
Thus the investment case in favor of office real estate is fairly strong, and prime structures, which have always attracted the bulk of institutional real estate interest, are the principle beneficiaries of it. General Partners of private real estate vehicles have been quick to launch new funds to accommodate this interest. However, investors in these funds are likely to find that it is difficult for their General Partners to find investments in which to deploy their capital. Property owners are naturally resistant to selling at what they also perceive as depressed prices. The flood of distressed selling that many investors anticipated has not materialized, as lenders have preferred to renegotiate rather than to foreclose, doubtless influenced by the same perception of the potential value of their collateral, as well as the substantial costs of foreclosure. The gradual recovery of the CMBS market will do nothing to discourage this preference, since it increases the liquidity of lenders’ positions and offers the prospect that, if they need to, lenders will be able to exit their positions on better terms than they could achieve through foreclosure and re-sale. As is frequently the case with depressed real estate markets, there is a constellation of interests that prevents the market from clearing rapidly. Thus opportunities to acquire prime office properties cheaply are less abundant than many institutions had expected.
The inevitable result will be that returns on the current vintage of prime office funds will be less than their most optimistic investors had hoped. Will they be less than their required rates of return? From the trough in Q4 1993 to the peak in Q2 2008 shown in the chart above, annual total returns from office properties were a quite satisfactory 8.9%, while for the whole period shown, including two drawdowns of 23% and 36%, the total return was a still-respectable 5.9%. The recent slump was more severe than the 1990 - 1993 decline, and recovery has been more rapid. Fundamental conditions – cap and vacancy rates, foreseeable newbuilding – support a return forecast that is at least as attractive as the 1993 - 2008 trough-to-peak experience. The major imponderable is the behavior of investors themselves. If institutional money continues to flood into the prime office sector, and owners continue to resist distressed sales, much of the price recovery will redound to the benefit of the existing owners and their creditors rather than the current vintage of new funds.

The speed with which returns have begun to recover suggests that this is precisely what is happening. If their required return is above, say, 6.5%, uncommitted investors would probably be wise to broaden their real estate search beyond prime U.S. office space to other building types, geographies or investment strategies. For example, the state of the market in the prime segment suggests that conditions for “value added” investment in office structures – those that require refurbishment – are close to ideal. Of course, if the “value added” office segment attracts significant institutional inflows, this will further dampen returns on prime office buildings, since the effect of “value added” investment is to increase the supply of prime office space through repositioning the buildings purchased.

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