Office sales are expected to gain momentum in the coming year as investors move further afield to acquire quality properties in an increasingly competitive arena.

Investors made one point crystal clear in 2010. They have a voracious appetite for low-risk office properties in top markets, and they're willing to pay a premium to get them. “I think we have all been surprised at how strong the demand has been for fully leased buildings,” says Charles Baughn, an executive vice president at Houston-based Hines.

That demand is evident in a sharp compression in cap rates. Cap rates for central business district office properties dropped about 100 basis points over the past six months to average 6.5% at the close of the third quarter. At the same time, cap rates for Class-A properties in “super core” markets of Washington, D.C. and New York have plunged below 4% in some cases, according to New York-based Real Capital Analytics.

“At this point in time, it is a tale of two different markets — the quality institutional assets located in New York and Washington, D.C., and then the rest of the country. But that is a trend that is going to change as we move into 2011,” says Dennis Friedrich, president and CEO of U.S. commercial operations for New York-based Brookfield Office Properties. Intense competition coupled with stabilizing market fundamentals is expected to give investors more confidence to expand their geographic scope.

Buyers are already starting to turn their attention to other primary markets such as San Francisco and Boston, as well as some of the top secondary markets like Houston and Minneapolis. But buyers also continue to target the relative safety of well-leased, well-located Class-A properties. “It will still take a bit more time for buyers to move into Class-B properties with occupancy issues,” says Friedrich.

Certainly, there are those buyers that also have been pursuing opportunistic deals. Yet distressed asset sales have been more scarce than anticipated as banks renegotiated terms and took write-downs. The volume of office properties falling into distress slowed to $3.9 billion in the third quarter, a big decline compared with the $17.4 billion in new distressed properties that emerged in the second quarter and $9.2 billion in the first quarter.

Bracing for a slow recovery

Weak office fundamentals are influencing buying strategies. “It is a real challenge right now to predict when we are going to start seeing strong rent growth,” says Baughn. “So people are trying to buy assets where that doesn't matter.”

But office fundamentals appear to have stabilized. The national office market has posted three consecutive quarters of fairly flat vacancies, while rents are at or near the bottom depending on the property type.

“We're looking at recovery, but a very slow recovery,” says Robert Bach, senior vice president and chief economist at Grubb & Ellis. The firm forecasts that the national office vacancy rate will end 2010 at 17.8%, reach 16.8% by the end of 2011, and improve to 15.4% by year-end 2012.

The lack of significant employment growth and the large volume of “shadow” space on the market will continue to stymie an office market recovery in 2011. Shadow space typically refers to office space that is empty, but not offered for lease or sublease. “That space needs to be filled up before new demand presents itself,” says Bach. When shadow space is included, the year-end vacancy rate rises to 22.2%, according to Grubb & Ellis.

Strong investor demand has helped to bolster deal volume in 2010, and that momentum is expected to carry over into 2011. An estimated $21 billion in office properties traded hands during the first nine months of 2010. Although that volume represents a healthy 83% increase over the dismal $11.4 billion in sales that occurred during the same period a year earlier, it is still well off the peak of $46.7 billion recorded in the first nine months of 2008, notes Real Capital Analytics.

Nevertheless, several factors will help spur higher sales in 2011. Returns on quality office properties remain favorable compared to alternative investments such as bonds and T-bills. Rising prices over the past six months will help encourage more owners to sell, which will help to alleviate the shortage of properties on the market. In addition, the financing climate continues to improve with more readily available, low-cost debt. “We're not back to the go-go years,” says Friedrich, “but for quality assets we are seeing lenders who want to lend.”