When Wells Real Estate Funds bought One West Fourth Street in July, the $77 million transaction had all the hallmarks of a Wells acquisition. The two-year-old, 431,000 sq. ft. office building was 92% leased by multiple credit tenants. Yet unlike much of Wells' $6 billion office portfolio that's spread among top-tier markets such as New York and Chicago, this property stands in the heart of Winston-Salem, N.C.

“This is one of the top office buildings in Winston-Salem,” boasts David Steinwedell, chief investment officer at Wells. Wachovia leases half of the building's office space, with the balance occupied by a law firm. The property's strong tenant base and downtown location weren't the only criteria that helped seal the deal for Wells, however: “We're building a geographically diverse portfolio,” emphasizes Steinwedell.

That's not to say that Wells, an Atlanta-based unlisted real estate investment trust (REIT), has lost its appetite for trophy office properties in the major metro markets. Instead, an overheated investment sales climate has forced the owner to cast a wider net, acknowledges Steinwedell.

From downtown Los Angeles to midtown Manhattan, feverish demand for Class-A product has driven sale prices up and yields down (see chart, page 24). SL Green Realty Corp., for example, sold One Park Avenue in Manhattan for $318.5 million in May. The REIT bought the midtown office tower in January 2001 for $233 million. By holding the property for a mere 39 months, SL Green fetched an $84.5 million gross profit on the sale.

In Chicago's West Loop, Class-A office deals are following a similar pattern: 222 South Riverside Plaza traded in July for $196 million. The sale resulted in a $73 million gross profit for owner John Buck Co., which purchased the property in September 2001.

In light of the nosebleed prices being paid for quality office properties in major cities, private investors in particular are pursuing alternative deals in secondary markets, loosely defined as metros that are not ranked among the top 25 in terms of total office inventory.

The pricing delta between top-tier office properties in big cities and these smaller markets may help explain why some investors are rethinking their strategies. During the second quarter, for example, a 247,075 sq. ft. office building in Tucson, Ariz., sold for $97 per sq. ft. Meanwhile, Boston's 73 Tremont Street — with only 50,000 more rentable sq. ft. — traded for $280 per sq. ft.

Honolulu, Hawaii, is among the cities on investors' radar screens. Over a 12-month period ending in July, the Honolulu office market recorded $510 million in sales, up from $20 million during the same period a year ago. What caused such a spike? A flurry of downtown office buildings hit the market over the past 18 months, resulting in a flood of offers.

The trend extends far beyond the tropics. In fact, an office building in Louisville, Ky., sold for a record $128.5 million in April. In another case, private Israeli investors bought a Jacksonville, Fla., office tower for $91 million in May. (These same investors bought Manhattan's famed Plaza Hotel last summer.)

“There's just so much capital out there now, and much of it will go into the secondary markets like Charlotte [N.C.] and Richmond [Va.], and that's spillover demand from the big cities,” says Josh Scoville, a research strategist at Property & Portfolio Research in Boston.

Indeed, the volume of office sales during July alone was $5.8 billion, reports Real Capital Analytics, double the amount in July 2003. Through the first eight months of 2004, deal volume hit $33 billion, a 66% increase over the same period a year ago.

Secondary Strengths

While a dearth of acquisition opportunities recently has driven a growing number of private investors into smaller markets, industry experts say that job and population growth projections bolster the argument that investors need to stay the course. Six of the 10 strongest job markets in the U.S. are secondary office markets, according to Property & Portfolio Research (see chart, page 25).

That job growth, in turn, has helped fill office buildings: Out of 13 markets nationwide that posted leasing absorption above 2% during the first half of 2004, 11 were secondary markets, reports Grubb & Ellis. Greenville, S.C., posted a 4% absorption rate during the first half of 2004, the highest in the nation. The average across the U.S. was a paltry 0.7%.

Why are many secondary office markets such as Greenville outperforming the big cities? Part of the reason, say sources, is that a growing number of corporations are relocating some of their operations to cut costs while still fulfilling their business needs.

“From an economic standpoint, there is much upside to being in a secondary market. For one thing, the cost of the ground is much lower and a business can sprawl in these markets,” says George Slusser, president of Parsippany, N.J.-based brokerage Coldwell Banker Commercial.

The cost savings that corporate tenants can achieve by setting up shop in a smaller market can be dramatic. Tobacco maker Philip Morris USA is spending $120 million to move 700 of its workers from 120 Park Avenue in Manhattan to an office complex in Richmond, Va. The decision to consolidate its operations at a sprawling campus in Richmond will save Philip Morris $60 million per year in occupancy costs, according to company officials.

Corporations such as Philip Morris also are benefiting from a growing population of skilled workers who reside in smaller cities, says Slusser of Coldwell Banker. “People really want to live in these markets, and it's also much easier for them to live there because the cost of housing is so much cheaper.”

The National Association of Home Builders reports that the median sales price of a single-family home in the Northeast last year was $190,500, compared with $157,100 in the South.

Sold on Cincinnati

Office developer Terry Huggins has experienced firsthand the benefits of investing in secondary office markets. In 1998, Huggins gambled on a vacant headquarters complex, previously occupied by ladies' apparel maker Nine West, outside Cincinnati, Ohio. Two light manufacturing buildings and a three-story office building occupied the 52-acre site. Nine West had gone bankrupt earlier that year and had vacated 210,000 sq. ft. of office space.

For Huggins, principal of Anacapa Development Inc. based in Santa Barbara, Calif., the deal introduced his boutique firm to a secondary office market. It took some nerve to enter into the transaction. “This deal scared everybody, and the local investors were too conservative to touch it,” says Huggins.

The developer undertook a seven-month renovation of the distressed property. Then, in 1999, the firm sold the empty office building to a Cincinnati area bank. While Huggins wouldn't state what the property sold for, he does say that the sale generated a 40% return.

Before buying the property in 1998, Huggins did his homework by learning as much as he could about the local economy and the commercial real estate market. He discovered that several Fortune 100 companies such as Procter & Gamble and Kroger were already major tenants in the local market. “After my experience there [in Cincinnati], I love doing deals in the secondary markets,” says Huggins.

But because smaller markets typically have a less diverse job base, any hiccups in the local economy can have an acute impact. In Louisville, the city's 9.1 million sq. ft. downtown office district recorded a 12.1% vacancy rate at mid-year, which compares favorably with an average vacancy rate of 17% in CBDs nationally, reports Grubb & Ellis.

The city took a hit in July when tobacco giant Brown & Williamson announced plans to vacate its Louisville headquarters as part of its merger with RJR Nabisco. Brown & Williamson occupies 200,000 sq. ft. of office space, most of it is concentrated in downtown Louisville.

While Louisville brokers don't expect the vacated space to capsize the market, it may take several quarters to backfill. As University of Louisville economics professor Paul Coomes notes, Louisville has not attracted the high-end office jobs snagged by Nashville and Indianapolis.

“We're wedged in the middle here between those two cities, and it's hard to tell if we're improving that quickly. There haven't been too many ribbon cuttings in Louisville lately,” says Coomes. Still, “your downside risk seems very low here and I wouldn't bet against the Louisville economy,” he adds.

Louisville's unemployment rate fell from 5.8% to 4.8% between July 2003 and July 2004, according to the Bureau of Labor Statistics. That's encouraging, but July 2003 marked the first time in more than a decade that Louisville's unemployment rate had risen to 5.8%.

Still, trophy office properties are in demand locally. Louisville's Aegon Center sold in March for a record price of $128.5 million, or roughly $225 per sq. ft. The tallest office tower in Louisville, Aegon includes 633,500 sq. ft. of rentable space and boasts an occupancy rate of 98.5%.

The seller was Hines Interests and the buyer was a private partnership led by New York City real estate investor David Werner. He's been known to go after far bigger game over the past 12 months. Werner led a group that bought Manhattan's Metropolitan Life tower for $675 million last year.

“The [Aegon] deal shows that quality real estate in a secondary market can achieve high prices,” says Craig Collins, an investment sales broker with Grubb & Ellis/Commercial Kentucky. “In the case of the Aegon Center, there were private investors bidding against institutions.”

Pension funds are much more hesitant to gamble on smaller markets, say industry sources. “The brunt of what most pension funds are buying is in the primary markets. But this money might go into a secondary market if the yield spread gets any wider,” says Stephen Coyle, managing director at Citigroup Property Investors.

One reason that institutional investors aren't flocking to secondary office markets is concern over possible exit strategies: Can they fetch a premium for their assets when they want to sell? “The perception is that liquidity just isn't as strong in secondary office markets,” says W. Cabell Grayson, senior managing director at CB Richard Ellis Investors.

Cashing Out

Conversely, real estate investment trusts (REITs) are exploiting a hot sellers' market. In July, for example, Trizec Properties sold a 274,000 sq. ft. office building in Columbia, S.C., for $27 million. The price was on the high side for this market, according to one local broker. The property had been on the market for more than a year. A Trizec spokesman says that the sale was in line with the REIT's strategy to exit most U.S. secondary markets within the next 12 to 24 months.

Cousins Properties is taking a similar tack. In September, the Atlanta-based office REIT sold two suburban office buildings in Austin, Texas, for $78.7 million. The buyer was a private equity fund that made an unsolicited offer.

It should come as no surprise that REITs are exiting the smaller markets, says Ray Torto, principal and chief strategist with Boston-based Torto Wheaton Research. “The REITs are income players, not growth stocks, and that explains why they are getting out of many secondary markets now. It looks like a great time to sell.”

If REITs are so focused on the big cities, why did they ever set foot in the secondary markets? Many REITs simply found themselves owning assets in smaller markets as a result of mergers, says Torto, and in the go-go days of the late 1990s there was no sense of urgency to sell because the economy was booming.

Even experts who subscribe to the idea that the market is peaking doubt that property values in both the secondary or primary markets will crumble overnight. Demand is so strong — and real estate as an asset class so popular — that values are likely to hold firm.

Indeed, Real Capital Analytics projects that cap rates for high-quality assets in primary markets may even fall by the end of the year.

While there are some caveats to growth in secondary markets such as low barriers to entry and a shallow pool of employers, Scoville of Property & Portfolio Research maintains that they will continue to see vigorous demand. “Investors are moving into these markets looking for one thing,” he emphasizes. “And it's the one thing they can't get in markets like Washington, D.C. and Manhattan — yield.”

SECONDARY MARKETS POST STRONG JOB GROWTH

Many secondary office markets posted better-than-average job growth between mid-year 2003 and mid-year 2004. Conversely, some of the primary office markets saw meager gains in employment. The national average during that period was 1.2%.

Secondary Markets % Growth Primary Markets % Growth
Jacksonville, Fla. 2.4% New York 1%
Honolulu, Hawaii 2.2% Dallas 0.6%
Fort Lauderdale, Fla. 0.5% 2.1% Los Angeles 0.5%
Richmond, Va. 1.5% Chicago 0.2%
Nashville, Tenn. 1.2% Boston 0.0%
Source: Property & Portfolio Research, Bureau of Labor Statistics