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Office Strategies:

Counting on rent increases and value-added plays

Soon after acquiring Equity Office Properties Trust for $39 billion, the Blackstone Group began flipping properties, eventually unloading $18.5 billion worth of office buildings in such cities as New York, Los Angeles, San Diego and Washington, D.C., including a $7 billion Manhattan tranche sold to Macklowe Properties.

It seems like a smart move for the New York-based private equity firm, says Steven Marks, a managing director with Fitch Ratings in New York: Blackstone seems to be divesting some of the healthiest buildings in the EOP portfolio for immediate gain and holding on to properties that face some operational issues to capture longer-term upside. But what do these deals portend for the new buyers—and what do they say about the direction of the office market?

“Blackstone was able to dump some of the properties for extremely low capitalization rates. The buyers have to believe there is some upside because right now these deals don’t pencil out,” says Marks. “If the cost of a deal is 4.5 percent and the cap rate is at 3 percent, that, out of the box, doesn’t work. It’s probably the perception of the buyers that they can raise rents and increase occupancies. They will cross their fingers and hope the economy and job growth stay strong.”

Marks is quite bullish on the office sector, especially since there is not a whole lot of new product coming in to the market and the recovery has been consistent. But, there could be an unsettling change ahead: absorption may slow and that could temper the office market recovery, especially in non-coastal cities with few barriers to entry.

Through 2006, effective rent growth in the office sector accelerated, while vacancies came down. “2006 was a very strong year for office space,” observes Sam Chandon, chief economist of Reis Inc., a New York real estate research firm. In fact, the office market had been on a three-year tear, with national vacancy rates declining from 16.9 percent in the first quarter 2004 to 13.1 percent in the first quarter this year. Over the same period, effective rents on a national level jumped 9 percent from $19.87 to $22.89. This year, effective rents are expected to grow 4.9 percent.

The problem is, says Chandon, net absorption in the fourth quarter 2006 and first quarter 2007 began to slow. “We are concerned as we move into 2007 that the expectation for economic growth and job creation will be more modest this far into the cycle and the demand for office space is slowing.”

Here’s a key point in Reis’ numbers: Office rents across 79 markets grew an average of 2.8 percent in the first quarter, 50 basis points better than the 2.3 percent in the prior quarter. However, the numbers are distorted by growth in the coastal markets such as New York, San Francisco and San Jose. In New York, for example, Cushman & Wakefield reports first quarter 2007 asking rents reached record highs with overall asking rents for Manhattan climbing to $53.43 per square foot and class A rents up to a record average of $64.54 per square foot.
If one looked instead at the median number, effective rents across the nation were up just 1.3 percent.

The question remains whether rent increases in the hottest office markets will turn into fatter cap rates for owners who have paid top dollar for office properties. “It would take ambitious projections in terms of rent growth in order to achieve yields higher than 3.5 percent to 4 percent,” says Mitchell Hersh, president and CEO of Mack-Cali Realty Corp., an Edison, N.J.-based office REIT. Hersh says that in midtown Manhattan, rents will have to approach $125 per square foot for owners to see cap rates climb back toward 5 percent. (In 2006, there were 41 leases in Manhattan above $100 a square foot, reports Cushman & Wakefield Inc.)

Because prices have risen so quickly, Mack-Cali has been extremely selective in its acquisition program. In March, the company entered the Manhattan market for the first time, purchasing SL Green Realty Corp.’s interest, about 524,500 square feet, in 125 Broad Street, a downtown Manhattan office tower, for $273 million.

Hersh says his company was attracted by the potential for rent increases. “The leases in that building are turning in the next couple of years and are substantially under what the market is today, so I can clearly justify buying the building at a 4 percent cap rate, or roughly $500 a square foot, because I know new product being built is not going to compete with me,” he says.

Last year, Mack-Cali entered the Boston area for the first time, buying in a joint venture a seven-property portfolio of Class A office and R&D buildings in the city’s northern suburbs. The properties totaled 666,697 square feet and were purchased for $53.6 million. At the time of the acquisition the buildings were less than 60 percent leased, so there was plenty of upside ahead.

In Boston, it’s all about potential rental growth, because cap rates have sunk to the mid-4 percent range for office buildings in the central business district. Last year, downtown Boston offices experienced 30 percent rent growth, says Marci Loeber, an executive director with Cushman & Wakefield in Boston. While it’s doubtful that kind of accelerating rent growth will be maintained, Loeber says, “there is potential for continued rent growth. That is what the buyers are saying and they are still purchasing buildings at a 4 percent cap rate.”

In one of the early flips from the Equity Office deal, Blackstone sold Russia Wharf, a major mixed-use project with office, residential and retail, to Boston Properties Inc. for $100 million.

The key factor for Boston office building investors is that rents remain below the “red zone,” or the highpoint in 1999-2000, which was the last market peak. Back then, downtown rents hit $80 to $90 a square foot, while the suburban space leased for $70. Today, says Loeber, downtown rents, even after a great 2006, fall into the $70 to $75 a square foot range, while suburban offices go for $40 to $42 a square foot.

Many investors buy real estate for different reasons but there are two basic categories of buyers for office buildings today, avers David Cohen, the Northeast Regional Director with GE Real Estate’s North America Lending Group in New York. First, there are the buyers who are looking to buy stabilized properties, possibly utilizing monies from 1031 exchanges. They are after purely stabilized assets with very little immediate upside and probably looking to fix long-term debt.

The second group of buyers consists of those strategic investors who see unrealized value in a building that can be achieved by such value-creation strategies such as filling large vacancies, rent growth or manipulating the asset or assets to increase the net operating income. These buyers are primarily looking for short-term fixed or floating rate debt with flexibilities ingrained in the debt structure to permit an effective value-creation strategy.

 “The value play is like a marriage, it’s in the eyes of the beholder,” says Cohen. “The sophisticated value-added buyers have some distinctive insight and knowledge, seeing something that somebody else did not, and because of that, they are going to be able to create value over the short or medium term to enhance the asset.”

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