The stakes keep rising for buyers hunting office properties in a crowded commercial real estate market. An excess of capital and persistently low long-term interest rates have given sellers the upper hand. Despite high prices, some buyers appear willing to go to any length to grow their portfolios.

This just summer, a joint venture of Hines Real Estate Investment Trust and Willette Acquisition Corp. paid a whopping $733 per sq. ft. for the 119,344 sq. ft. Unilever headquarters in Greenwich, Conn., reports Real Capital Analytics. Record sale prices have already been set in 18 markets this year.

“Investors are all over the board on prices,” says Ray Torto, principal and chief strategist at Boston-based Torto Wheaton Research. “There are some deals we hear about that make us shake our heads.”

To survive in this jungle, investors need to be nimble and cautious. Buyers paying ultra-high prices for fully leased buildings, in particular, place themselves at risk of being unable to recoup that value in a future sale, says Paul Briggs, senior real estate economist at Property & Portfolio Research in Boston. “A lot of these firms are skilled operators, but they're removing their competitive advantage by buying these fully leased buildings with a fixed income stream,” Briggs says.

Nationwide, CBD office sale prices hit $256 per sq. ft. in the second quarter, a 25% jump in six months. Through June of this year, sales were just under $43 billion, a 48% increase from the same period last year, according to Real Capital Analytics. “I'm just amazed at the depth of the market right now,” says Bob White, president of the New York-based researcher, which tracks deals $5 million and higher. “We're seeing new players emerge every day.”

With so much demand for product, many of the nation's largest office owners are taking the opportunity to prune portfolios by selling unwanted assets at a premium.

But these players have to deploy their money, too. And there's the catch. How can they produce great returns when they have to pay top dollar to restock their portfolios?

The options available to REITs include reinvesting sale proceeds in new acquisitions, buying back shares, paying down debt, or paying a higher or additional dividend, according to Barry Vinocur, editor of investment newsletter Realty Stock Review. “In the end, people are trying to maximize returns,” Vinocur says, “but it's not as straightforward as some people make it sound.”

Indeed, the excess of money chasing assets is making it harder for office owners to find deals that are not overvalued — at least by historical standards. Over a two-year period ending June 30, the average capitalization rate — or the initial return to the buyer based on the purchase price — fell from 8.6% to 7.1% for CBD office buildings nationally, according to Real Capital Analytics. Suburban cap rates have fallen even further, from 9.2% to 7.5%, during the same period.

Strategies for survival

“Being a value investor today and finding a good acquisition is like finding a needle in a haystack,” says Jeff Johnson, chief investment officer at Equity Office Properties Trust. The nation's largest office REIT looks for properties to hold long-term and needs to be sure that income will cover the purchase price and deliver an acceptable return. That's a tough assignment now. “We looked at $20 billion of assets to buy our measly $900 million worth of properties last year,” says Johnson.

To thrive in this overheated market, owners are compelled to think more creatively. When they can't justify a buy, it may make sense to partner. When there's no affordable inventory in the markets where they usually shop, they cast their nets more widely. When the most desirable properties are overpriced, they look at more affordable — and riskier — situations.

It's a market that requires some fancy footwork. Fort Worth, Texas-based Crescent Real Estate Equities Co., for example, knew it couldn't outbid pension funds in vying for acquisitions. So instead of being beaten, the publicly traded REIT joined pension funds in joint ventures, converting nearly half of its office portfolio to joint-venture ownership.

The company has sold about $3.5 billion of real estate since 1999 and has entered into office joint ventures valued at $2.3 billion, making it the largest joint venture partner for both JP Morgan Asset Management and General Electric Pension Trust.

In its joint ventures, Crescent holds a 20% to 25% share of an asset, collects leasing and management fees from its partners for operating the property, and earns additional incentive pay when the property exceeds revenue goals. The strategy has increased the company's return on equity by 300 to 600 basis points, says John Goff, Crescent's vice chairman and CEO.

For example, a building that returned 12% annually to Crescent as the sole owner now generates a return of 15% to 18%. “We've tried to embrace a fundamental change in the industry that's going to be around for the next 10 to 15 years,” Goff says. “We don't compete with pension fund capital, but harness the power of it.”

Emphasis on core markets

For Trizec Properties, a Chicago-based office REIT with $4.5 billion in assets that's headed by Canadian mining entrepreneur Peter Munk, the strategy is to focus its portfolio on a half-dozen major markets. That decision has resulted in Trizec exiting eight smaller cities, including Baltimore and Memphis. “Some of those were perfectly good markets, but we didn't think we could grow much there. We wanted to be in cities that had deeper, more liquid markets both from a leasing and equity standpoint,” says Brian Lipson, Trizec's executive vice president and chief investment officer.

Since early 2003, Trizec has sold 9.7 million sq. ft. in 22 properties for approximately $1 billion. It has sold all non-office assets, including land, three retail properties including Hollywood & Highland in Los Angeles, and a technology center in Canada.

The company is reinvesting those proceeds in its core markets in a strategy Lipson calls “geographic diversification with submarket concentration.” Simply put, that means gaining enough presence in each of its core markets to get a shot at virtually every leasing deal in those cities.

Like Johnson at Equity Office, Lipson says his company typically analyzes 20 potential deals for every completed acquisition. The company has closed north of $1.2 billion in office acquisitions since last August, most recently with the $356.7 million purchase of Figueroa at Wilshire in Los Angeles on July 20.

Trizec tries to maintain discipline, walking away from deals that don't meet its performance criteria. “If we don't get a deal in Washington today, we may get one in Los Angeles tomorrow,” says Lipson. The alternative — focusing on one market or one asset — creates pressure to place capital within that market, even in the absence of good deals. “That's where you can really get some high bidding going,” he says.

Like Trizec, Equity Office is using high market liquidity as an opportunity to concentrate assets in markets with the greatest potential. But the nation's largest office owner, with 117.4 million sq. ft. in its portfolio, has a different definition of core markets that includes San Francisco, Austin and several other cities absent from Trizec's list. Equity is also exiting Houston and Dallas, where Trizec wants to increase market share.

Leaving ‘Big D’ in the dust

Equity sold nearly 2.5 million sq. ft. in the Dallas area in the second quarter, including the 1 million sq. ft. Colonnade I, II and III. At the same time, Equity expanded its presence in Austin by purchasing the 272,000 sq. ft. Research Park I and II.

What makes Austin a strategic market for Equity? “Dallas and Houston have fewer supply constraints to new construction, while Austin's demand seems to be just as attractive as Houston and Dallas,” says Johnson, the chief investment officer.

So far this year, Equity has sold 9.1 million sq. ft. of assets totaling $1.6 billion and purchased 2.7 million sq. ft. in 20 buildings for $860 million. The company's acquisitions will leap another $505 million this fall with the purchase of a 1 million sq. ft. stake in the Verizon Building at 1095 Avenue of the Americas in New York.

Equity is on a five-year plan to achieve annual deal volume between $1 billion and $2.5 billion, resulting in an average net new investment of $500 million each year, Johnson says. That involves acquiring core assets — which Johnson defines as well-located, Class-A office buildings in the company's core markets — and selling properties that don't fit that profile. “Every building we have bought this year and last year has been a strategic asset in a strategic market,” he says.

How does Equity target buildings in this high-priced environment? The REIT primarily looks for buildings with some vacancy and potential to increase value through leasing. “But it's difficult to find those properties,” Johnson concedes. Most of the behemoth REIT's recent buys originated without the property being marketed for sale, or involved some special circumstance that made the asset a good buy, he says.

A good example is Research Park in Austin. Los Angeles-based Maguire Properties acquired the property as part of a 5 million sq. ft. portfolio in March. That acquisition was chiefly intended to acquire California properties, so the new owner welcomed a quick sale of the Austin asset to Equity Office.

Buying vacancy a smart move?

Houston-based Hines, with 33.9 million sq. ft. of office space in its portfolio, is determined to be a net buyer this year despite record prices, says Executive Vice President Charlie Baughn. “This year we will probably buy more as a company than we have ever bought,” he says.

Since mid-year 2002, Hines has sold 22 million sq. ft. in 48 office properties and has acquired 9.4 million sq. ft. in 24 properties. Baughn declines to discuss deal values for the privately held firm.

Why stock up now? Baughn believes the period of shrinking capitalization rates that began in 2002 can't continue much longer, so he doesn't expect prices to dramatically increase due to further cap-rate tightening.

Instead, Baughn says, the sector is entering a period during which the emphasis will be on smart management — increasing value through upgrades, increased efficiency and improved leasing. “The successful firms will be those that have the ability to execute a strategy,” he says. “Buying vacancy is the next area of opportunity to continue making money from real estate.”

Baughn won't specify where he sees opportunities, but a San Francisco purchase is in the works, and Hines is hunting deals in Chicago and Seattle. “We'd love to buy something in New York or Washington, but the pricing would be difficult,” Baughn says.

Risk-takers rewarded

Briggs, the economist at Property & Portfolio Research, endorses the general strategy of buying vacancy. Like Baughn, he says prices are at or near their cyclical peaks in most major and secondary markets. That means that management acumen, not a rising tide, will be required to extract value from buildings going forward.

And that, he says, means it is time to take some risks. “Now is the time to buy properties with a little more vacancy, a little more risk on the occupancy side,” he says. “It gives the buyer some opportunity to add value.”

The prospects for boosting occupancy have been improving since last year. The national office vacancy rate, which fell from 16.6% at the start of 2004 to 15.4% at year's end, fell to 15.1% in the first quarter of 2005, according to Torto Wheaton Research.

Behind the national averages are standout performances in markets such as Austin, Miami, Las Vegas, Fort Lauderdale, Tampa and California's Orange County, where vacancies dropped a full percentage point during the quarter. (Vacancy increased in a handful of markets including San Diego, San Jose and Charlotte.)

The supply factor looms large

Improving occupancy rates will not just prevent prices from falling — they will actually lead to continuing price appreciation, says James Corl, chief investment officer at New York-based money manager Cohen & Steers Inc., the largest manager of U.S. real estate securities.

Office construction starts in May fell 9% from the previous month and have essentially stalled following improvement last year, according to McGraw-Hill Construction. With historically low construction, falling vacancies should lead to higher rents and higher property values in just about every market. “It's unlikely that two years from now, when the average occupancy has gone from 85% to 88% and asking rent has climbed from maybe $21 to $24 per square foot, that values are going to be less than they are today,” he says.

The implication for investors hacking their way through the office market jungle is to resist the feverish temptation to sell, and to keep hunting for acquisitions. By Corl's reasoning, improving fundamentals will fetch even higher prices for office properties a year or even two years from now.

That's why Cohen & Steers has invested more than $4 billion, or nearly 25% of its portfolio, in office companies, Corl says. “Some part of the recovery has been priced into current asset pricing, but there's still a huge amount of money to be made because people aren't realizing it's going to be a long time before new construction caps rental growth.”

A critical variable is new office construction, which could mitigate occupancy gains by increasing the supply. Cohen believes that it would take at least two years for that much development to reach the market.

But PPR economist Briggs says the stage is set for a construction surge, with the number of office projects in the planning stage up 132% from a low point in December 2003. “Many people might be expecting a five-year-plus recovery in the office market, but given the intense interest in having real estate in your portfolio, there's a risk that supply could ramp up more quickly.”

Matt Hudgins is an Austin, Texas-based writer.

CalPERS pursues higher returns

Is the California Public Employees Retirement System (CalPERS) dialing back on real estate investment as some news reports have suggested? Quite the contrary, says Michael McCook, senior investment officer of real estate for the $186 billion fund. In fact, CalPERS plans to plow an additional $5 billion into real estate in as little as two years.

The notion that CalPERS is scaling back on real estate, which has been widely reported, stems from a slight misinterpretation of revised investment goals announced in December, McCook emphasizes. As of late December, CalPERS had about $13 billion, or 7% of its portfolio, invested in real estate when it significantly expanded its real estate investment range to give the pension fund giant more flexibility.

Historically, that investment range was from 7% to 11%; today, it stands at 4% to 12%. McCook says industry observers who interpret that move as a reduction in CalPERS' total real estate allocation are only comparing the midpoint targets of the old and new ranges, which fell from 9% to 8%. The bottom line is that reaching even the new, lower target would amount to a $1.86 billion increase over its December holdings.

The confusion is understandable, considering CalPERS and its partners have sold $6.9 billion of real estate since the start of the fourth quarter. But acquisitions have already hit $1 billion this year, and McCook says more are on the way. With CalPERS' current real estate holdings down to 5% of total investments, the fund needs to invest more than $5 billion in real estate just to hit its 8% target.

Under a new strategy, CalPERS is pulling away from well-stabilized, or core, assets that provide a steady but unspectacular yield, and moving toward properties with a greater potential to increase in value. “Where we've sold a fully leased, Class-A office building, we may buy another Class-A building that is only 50% leased,” McCook says.

Why the increased risk? CalPERS figures that it won't need to draw on capital to pay retirees until sometime between 2015 and 2020. That gives McCook about seven years to seek better returns before CalPERS will need to rebuild its portfolio of core real estate.

“The market was getting frothy with low interest rates and low cap rates, so it gave us the perfect exit to go into the new strategy,” McCook says. “We were able to sell, take significant amounts of money off the table, and look to a strategy over the next five years that's more investment-return oriented.”
— Matt Hudgins