For much of 2010, investors have been fixated on prime coastal or so-called gateway cities, snatching up trophy office towers in their quest for quality properties. But rising prices in those prime locations are sending some investors to the nation's heartland, potentially jump-starting the next phase of an office buying cycle. Some investors in the past have dismissed the interior markets as “flyover” country — areas viewed from a plane en route to the coasts.

“The difference in yields between the favored markets and the heartland markets has gotten big enough that it's really deserving of attention, and investors are certainly getting tempted if they haven't acted yet,” says Robert White, president of New York-based research firm Real Capital Analytics (RCA).

The investment gulf between markets in the U.S. interior and their coastal brethren is huge. Through the first three quarters of 2010, the sales volume of office properties priced at more than $5 million totaled $1.4 billion in Washington, D.C. alone, versus $135 million in St. Louis and $400 million for all tertiary Midwest markets combined.

But for investors, the heartland could be the next big thing. “There is no doubt the secondary markets are going to pick up,” says White. “It's an easy call right now to get in front of the capital and investors that are focused on a handful of markets and who within a year are going to have to broaden their horizons a lot more.”

Many recent office acquisitions in non-coastal markets tend to have high occupancy rates and command choice locations, says Victor Calanog, chief economist at Reis, a New York-based research firm. “A lot of these tertiary markets, like St. Louis, Indianapolis and Oklahoma City for example, did not have a lot of jobs being concentrated in the financial services sector and really didn't take that much of a hit versus the New Yorks and San Franciscos of this world. So volatility is definitely there as the downside for the primary gateway city markets.”

Nationally, the most active buyers have been institutions and real estate investment trusts (REITs), which now control billions of dollars in potential investment capital, much of which is still sitting on the sidelines. Typically these buyers' strategy is to stick to larger, better known core markets, so not surprisingly most of the really big deals have occurred in major coastal markets including New York, Washington, D.C. and San Francisco.

Recent data bears out the exuberance investors have shown for high-priced assets in gateway cities. According to RCA, transaction volume for properties priced at $25 million or more soared 126% in the first three quarters of 2010 compared with the same period a year ago.

But gateway cities pose stiffer challenges these days. Dropping capitalization rates, a lack of truly distressed bargain properties coming to market and greater volatility in market cycles is putting more pressure on buyers to look beyond gateway purchases. The average cap rate in the Washington, D.C. market was 6.7% at the end of the third quarter, while the average cap rate in tertiary markets nationwide was 9.5%, according to RCA data.

Heartland offers stability

Office markets in the nation's heartland offer what Calanog terms “a diversification play,” providing more stability in terms of income during the peaks and valleys of market cycles. “From the fundamentals side, because of the distress that a lot of gateway cities had to go through this time around [in the recession], a lot of investors may shy away and look to the heartland markets as potential diversification opportunities,” says Calanog.

The growing strength of the commercial mortgage-backed securities (CMBS) market could benefit sales in markets far from coastal cities. Standard & Poor's Rating Service predicts $4 billion to $8 billion of new CMBS issuance in fourth- quarter 2010, the most since early 2008.

“It's amazing how much the debt markets have improved over the last 90 days,” says White. “CMBS is driven by diversification by property type and by market, so as it ramps up it will benefit activity in the secondary markets.”

One of the biggest challenges facing investors in secondary and tertiary markets is the lack of trading volume. “We have pretty good price discovery for trophy assets in New York and D.C., but we don't have that many data points in the secondary markets,” says White.

Calanog agrees. “Because folks are still fairly risk-averse when putting their money into commercial real estate, they want exit options as well. Unfortunately, only the gateway cities offer those exit options in terms of higher transaction volumes at this point in the cycle.”

The lack of deal flow forces investors to focus on Class-A office buildings in city centers as opposed to suburban properties. “If you find a property in Indianapolis that's 95% occupied and there are long-term leases that don't roll over for another three or four years, and you can negotiate a good price, then you're going to be sitting in an income-generating asset with very little volatility,” says Calanog.

There is less potential rent growth compared with gateway cities, but there's also less downside risk, he notes.

The primary drivers of leasing demand now are the health of the economy and expected job creation. Most signs point to a prolonged, meandering recovery.

“People need to temper their expectations by how quickly jobs will be created,” says Calanog. “The office sector, unfortunately, is critically dependent on job creation to lead the way for absorption of space.” Unless steady job growth occurs, he believes absorption of office space may not turn positive in an appreciable way until at least 2012.

And some cities are still dealing with job losses, including the many heartland cities that have suffered severe cuts in public sector funding. For example, the East St. Louis City Council recently laid off 19 of its 62 police officers because of tax revenue shortfalls. “State and local government consumption, which includes hiring and firing of teachers and workers, has been in a downward spiral for eight quarters and doesn't look like it's going to be rising anytime soon unless this recession really hits bottom and aggregate demand really rises,” says Calanog.

What follows is a look at how four cities in the nation's heartland have fared recently and what investors can expect from them in the months ahead.

Denver

The worst of the recent economic recession may be over for the Mile High City. In a sign of investors' interest in the office market, in early November private equity firm Walton Street Capital paid $49.5 million for a 317,000 sq. ft., three-building complex in a new mixed-use project known as Broadway Station taking shape downtown.

And earlier this year, Commonwealth REIT purchased RE/MAX International's headquarters for $75 million. In fact, investment sales volume in the first three quarters of 2010 totaled $381 million, more than double the $171 million for the same period in 2009. Improving economic conditions are spurring investors into action.

“Denver has weathered this economic downturn with market fundamentals healthy relative to most other major markets,” says Lauren Douglas, director of research at Newmark Knight Frank Frederick Ross, a Denver-based real estate service provider.

The local unemployment rate declined to 7.9% in July 2010 after peaking at 8.6% in June 2009, according to the U.S. Bureau of Labor Statistics. The metro Denver unemployment rate remains the second lowest among the nation's largest metropolitan areas.

Continued improvement in the Denver office market is also bolstering investor confidence. According to CoStar Group, absorption totaled 30,339 sq. ft. in metro Denver in the third quarter of 2010, while year-to-date absorption totaled 1.25 million sq. ft. That compares to negative 229,230 sq. ft. in the third quarter of 2009 and negative 930,000 sq. ft. in the first nine months of 2009.

Meanwhile, sublease space dropped by 163,000 sq. ft. in the third quarter, according to Delta Associates, the research division of Transwestern. There is some 1.2 million sq. ft. of sublease space on the market, representing only 0.9% of the standing inventory.

The overall office vacancy rate was unchanged in the third quarter of 2010 at 14.1%, which is down from 14.8% a year ago.

The direct office vacancy rate stood at 13.2% in September, up from 13.1% in June but down from 13.6% a year ago.

Construction activity has remained constant, with 826,512 sq. ft. of office space under construction or renovation as of the third quarter, compared with 837,153 sq. ft. at mid-year and 1.8 million sq. ft. in the first nine months of 2009. The good news: As of September, space under construction is 47% pre-leased, compared with 45% a year ago.

In May, Denver-based Westfield Co. officially cut the ribbon on 1800 Larimer, a new 22-story, 500,000 sq. ft. office tower and the first to be constructed in downtown Denver in the past 25 years. And surprise, office development opened 88% leased.

Indianapolis

The Hoosier State's capital city seems to have reached bottom in office fundamentals after two years of negative indicators.

According to real estate services firm Cassidy Turley, the vacancy rate in Indianapolis' 32 million sq. ft. office market dipped from 21.9% in the second quarter of 2010 to 21.5% in the third quarter. That compares with 20.1% in the third quarter of 2009.

“Signs indicate that the market has bottomed out and is poised for a rebound,” says Katie Sobotowski, an associate in the office advisory services group at Indy-based Summit Realty Group/Cushman & Wakefield Alliance.

Indianapolis' employment market is expected to grow by 0.9% in 2011, according to Moody's economy.com. That is the first positive movement in job growth after one-year declines of 4.5% and 0.9% in 2009 and 2010, respectively.

The downtown vacancy rate took a major hit, however, when pharmaceutical giant Eli Lilly decided to leave two buildings totaling 321,000 sq. ft. at its Faris Center campus. That move drove up the vacancy rate for Class-A downtown buildings to 21.2% at the end of the third quarter, up from 17% in the second quarter, according to CB Richard Ellis.

The overall office market saw negative absorption of 129,000 sq. ft. through the first nine months of 2010. Downtown registered 88,000 sq. ft. of positive leasing and the suburbs a negative 217,000 sq. ft.

Investors can take comfort in the fact that building cranes are still mothballed in Indianapolis. More than 20 buildings and 1.1 million sq. ft. of new office projects remain on the drawing boards, but it is highly unlikely that developers will dust off those plans anytime soon.

Yet at least one of the largest development projects is moving ahead, thanks to some high-powered partners. Eli Lilly is working with the city of Indianapolis, the State of Indiana and Buckingham Cos., an Indianapolis-based full-service real estate firm, on a $150 million, mixed-use project called North of South.

The new 10-building development, sprawling on 10 acres near Lilly's corporate campus, will become a downtown centerpiece and is expected to spur additional development. It will include a 152-room Dolce hotel, 320 apartments, 40,000 sq. ft. of restaurants and retail space, a 10,000 sq. ft. business incubator for life-science companies, and a 75,000 sq. ft. YMCA. Groundbreaking is scheduled to begin by the end of 2010, with development expected to take two years.

Oklahoma City

It is no great secret that the oil and gas industry continues to dominate the business landscape of Oklahoma's capital city. And soon, the city's skyline will testify to that. Hines is developing Devon Energy's new downtown corporate headquarters, a 50-story, $300 million tower scheduled for completion in 2012. The building will be the tallest in the state.

“It is absolutely a game changer for Oklahoma City,” says Mark Beffort, managing director of Grubb & Ellis/Levy Beffort. The structure will symbolize Oklahoma City for many years, he adds.

The downside to Devon's relocation, however, is that the company will vacate some 800,000 sq. ft. of space in five downtown office buildings. The potential impact on local owners has been debated.

One piece of that puzzle fell into place in October, when local real estate pro Ford Price, managing director of services firm Price Edwards & Co., purchased 20 N. Broadway, Devon's current headquarters building. It sold for nearly $22.5 million, or $73 per sq. ft.

Beffort, who is a part owner in the other four buildings occupied by Devon, believes most of Devon's vacated space will be absorbed or redeveloped. “I firmly believe that at least two of those other options will be absorbed prior to Devon vacating their space.”

Much of Beffort's optimism stems from continued moves by city government to invest in its downtown core. In December 2009, citizens approved one of the nation's largest public works projects, the $777 million MAPS, short for metropolitan area projects. It calls for a convention center and downtown central park.

Also on the horizon is the redevelopment of 750 acres directly south of downtown in an area known as the Core to Shore. Over the next 20 years the city hopes to spur the development of offices, apartments, hotels and retail.

A setback to the recent positive moves occurred in September, however, when the owners of one of the city's oldest landmarks, First National Center, filed for Chapter 11 bankruptcy protection. Los Angeles-based Milbank Real Estate purchased the art deco-inspired 32-story tower, built in 1931, for $21 million in 2006. Now it will remain in workout mode until its finances can be restructured.

St. Louis

The Gateway City has attracted investor interest this year. In February, KBS REIT II, a public non-traded real estate investment trust, purchased two high-profile office buildings, Pierre Laclede Center I & II in suburban Clayton, for $74.2 million. The seller was BPG, a private equity firm in Philadelphia, which had bought the buildings for $75 million in 2006.

The property fits the profile for most heartland acquisitions in recent years, with a high occupancy rate of 94% and a reputation for being one of the top office assets in its market with a prime location.

“Pierre Laclede Center is a high-profile, trophy-quality asset in the strong Clayton submarket, offering an attractive mix of prestige, location and on-site amenities,” says Bill Rogalla, KBS senior vice president of acquisitions.

This was the firm's second major investment in the St. Louis metro in the last few years. It snapped up the 335,000 sq. ft. Plaza in Clayton office building in 2006 for $93.28 million.

Market observers are hopeful that the KBS deal will stimulate more transactions, but systemic challenges lie ahead.

According to St. Louis-based Cassidy Turley, office occupancy is not expected to improve over the next few months due to continued stagnant employment growth. The city added 6,700 new jobs in early 2010, but since then job growth has stalled. Still, local employment is expected to grow 1.1% in 2011, the first year-over-year gain in the past three years, according to the Bureau of Labor Statistics.

The St. Louis office market absorbed 270,000 sq. ft. in the third quarter, primarily due to completion of the new 17-story Centene Building in Clayton. That space opened in November nearly 97% occupied. Unfortunately it was at the expense of the downtown submarket, where law firm Armstrong Teasdale vacated 123,000 sq. ft. in the largest office building in the district, One Metropolitan Square.

Little new office space is expected to hit the market any time soon. Only two new developments totaling 270,000 sq. ft. are under construction.

Across the market, the office vacancy rate ticked up slightly in the third quarter to 13.8% from 13.5% in the previous quarter. But lease rates have grown by 1% year to date, and sublease space has dropped by 14% from a year ago

That's a good sign for investors, according to Dennis G. DeSantis, senior director at locally based Gateway Commercial/Cushman & Wakefield Alliance. “The absence of new construction — and the stricter underwriting standards caused by the ongoing regulatory stress of financial institutions — will continue to help stabilize the St. Louis office market.”

Ben Johnson is a Dallas-based writer.