Secondary Office Markets – Where Do We Go From Here?

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Investors targeted top-tier, low-risk office assets in primary markets last year, while opportunity funds sought a once-in-a-generation prospect to acquire quality properties at deep discounts. Distressed sales disappointed the wall of waiting capital as lenders extended and modified loans on quality assets, parting only with true high-risk, low-end properties, generally in tertiary locations.

Recompressed cap rates in the top tier and limited volume at the bot­tom have moved capital toward the middle-of-the market bell-curve, benefiting Class B properties in non-prime but still good locations. Initial yields for deals in secondary markets compressed 20 basis points in the second half of 2010 into the high-eight percent to low-nine percent range and will continue to tighten this year.

While private buyers accounted for nearly half of the volume of office deals made in secondary markets dur­ing 2010, institutional investors and public REITs increased their pres­ence, comprising 26 percent and 19 percent of dollar volume, respectively. Nearly 70 percent of the dollar vol­ume from institutional investors was recorded in Seattle-Tacoma, Denver, Phoenix and Charlotte. Vacancy rates in these markets will improve by be­tween 60 basis points and 100 basis points this year, on pace or exceeding the projected U.S. vacancy decline of 60 basis points.

Opportunity Is Knocking

Buyers looking to acquire distressed office properties in secondary markets may find value-add opportunities in Phoenix, as the metro has the largest inventory of assets with delinquent loans or REO, with roughly $1.4 billion in distress. Although vacancy rates will remain elevated in Phoenix until employers backfill underutilized space, the average rate will drop 90 basis points this year to 25.6 percent as construction slows to levels last recorded in the mid-1990s and office-using job growth accelerates leasing activity. Additionally, prices in the metro fell 23 percent last year to $130 per square foot, compared with a four percent decline nationally. In that time, average cap rates in Phoe­nix retreated 20 basis points to the mid- to high-eight percent range.

Other distressed-asset opportunities may be found in Denver, where $800 million in distressed office proper­ties pushed down the average price 20 percent last year to $112 per square foot. Similar to Phoenix, office construction in Denver will fall to the lowest level in 15 years in 2011, and office-using employment growth will accelerate. Vacancy rates in the metro area will retreat 80 basis points this year to 19.5 percent, largely driven by improving performance in the CBD.

In Orlando, meanwhile, the inventory of distressed office properties is under $300 million; however, small inves­tors will continue to re-enter the mar­ket this year as financing improves and space demand outpaces supply growth. Vacancy rates will retreat 60 basis points to 16.5 percent, while effective rents will rise one percent to $16.80 per square foot. With average prices down 23 percent year-over-year in 2010, value-add investors able to put considerable cash into deals will begin to stir as the year progresses.

By the second half of 2011, buyer demand will spread toward Class B assets that provide a value-add or turnaround path. Improving fun­damentals will play a clear role in boosting investor interest and moving capital down the quality chain. This will prove especially true for Class B and lower-quality properties as reduced rents in the top tier attract tenants and a slow recovery in startup formations and muted small business expansion limit demand.

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