Late last year, as conditions in the office sector declined and price tags for buildings continued to rise, industry pundits warned of a possible investment bubble.

Indeed, all the ingredients were present. Like the suckers who jumped into the Nasdaq as it was making its last record-setting climb, new investors were plowing money into commercial real estate. As the money flooded in, sale prices soared 43% in 2002, according to New York-based real estate research firm Real Capital Analytics, which tracks sales transactions of $5 million and higher. Meanwhile, net absorption has been negative for seven quarters and the national vacancy rate stands at 17.5%, according to Grubb & Ellis. And asking rents have fallen.

Still, it looks like the bubble remains more of a threat than a present danger. The latest positive sign: Several Manhattan trophy properties have been yanked from the market after initial bids came in lower than expected. For example, 850 Seventh Ave. in Midtown Manhattan was withdrawn in December after bidders balked at the $234 per sq. ft. asking price for a building with a 17% vacancy rate, including sublease space. Another property in Midtown, 660 Madison Ave., was taken off the market recently after its owner failed to secure a $640 per sq. ft. bid.

The message: There are limits. Even though there may be newbies in the market, they aren't dumb. Once you get beyond the very top-end trophy properties that have good occupancy — like Manhattan's 399 Park Ave., which went for $626 per sq. ft. — there is no sign of a feeding frenzy.

“On lesser-quality properties, prices have to drop or else there will be no buyers,” says Anthony Malkin, president of W&M Properties, a real estate management and acquisitions firm. He says that any sign of irrational exuberance is on the part of sellers who think they can secure record prices for lesser-quality buildings. “There's a big gap in pricing once you get away from these trophies,” he emphasizes.

So, did the investors who snapped up those hot trophy buildings last year overpay? Edward Linde, CEO of Boston Properties, which bought 399 Park Ave. from Citigroup, scoffs at the suggestion. “We bought this building because there is real value there,” he says. The building will reportedly generate an annual return of 8.25% for the first three years of ownership, which is higher than analysts had predicted before the sale closed.

At the end of 2002, PNC Real Estate Finance, Real Capital Analytics and Grubb & Ellis issued a joint report on the office market in which the authors concluded that, despite record prices, a bubble of unjustified and unsustainable price appreciation was not likely. “Our findings clearly indicated that investors are exhibiting rational exuberance as they consider investment options, choosing to buy the best assets in the best markets for high prices in order to avoid market risk,” writes Bob Bach, national director of market analysis for Grubb & Ellis.

“This is a rational response to historically low mortgage rates, the lack of compelling investment alternatives, and the willingness of investors to trade lower yields for lower risk in the post-bubble, post-Enron era,” Bach adds.

“This is clearly a bifurcated market,” concludes Andrew Merin, executive vice president at Cushman & Wakefield. “People are richly rewarding those properties with low vacancy and penalizing those with high vacancy.”

The possibility of overpaying is not completely remote. “At a certain point, you value the leases more than you value the building,” says Lawrence Fiedler, professor of real estate at New York University's Real Estate Institute. Fiedler speculates that many buyers are paying above replacement cost for these assets and warns that aggressive investors can easily misjudge the market when bidding wars are commonplace.