A potent combination of improved returns in the present and growing confidence in the future is propelling office markets forward as 1996 begins. As supply/demand measures have advanced, the stream of capital flowing to the office sector has gathered force. Investors, while determined to avoid the excesses which led to the loss of billions in this property type in the downcycle, perceive that the odds have shifted in favor of offices. We are therefore prompted to reaffirm our belief, highlighted in this space a year ago, that offices would prove the "hot" property type for 1995 and 1996.
Pension funds, appetite for additional office properties has been whetted by solid improvement in the performance measures tracked by the National Council of Real Estate Investment Fiduciaries (NCREIF).Total returns for the $7.3 billion of pension fund equity investments in offices were a solid 5.9% for the year ended Second Quarter 1995, the best showing for the property type since 1986. Income returns for the year were 9.9% of the market value of these assets. Although the funds were lightening their portfolios in the western region of the country, where values were still in decline in early 1995, they were buying properties in the East and in the Midwest, regions where income yields were above the 10% mark.
Returns to securitized equity were an excellent 18.7% for office REITs in the 12 months ended September 1995. Investors realized 6.7% dividend yields to go along with 12% price appreciation in office-concentrated investment trusts, according to Alex. Brown & Sons. Yet, these returns lagged the benchmark S&P 500 Index, which returned 28.6% for the period. The REITs, growth imperatives saw acquisition activity accelerate through the first half of the year. Tracking National Association of Real Estate Investment Trusts (NAREIT) data, Landauer counted more than three dozen office purchases by REITs through July 1995, with aggregate prices above $300 million. REITs continue to prefer smaller, suburban properties and are buying at capitalization rates in the 11%- 12% range.
The life insurers are also solidly back in the market with commercial mortgage capital oriented to the office sector. Over $1.8 billion in new insurance company mortgages was issued in 105 office transactions during the second quarter of 1995, bringing the 12 month total to $4.3 billion in loans. Underwriting criteria are still holding reasonably firm. The average duration of the loans is ten years, with debt service coverage of 1.55 times over net income. American Council of Life Insurance (ACLI) statistics indicate cap rates at 9.7% for offices at midyear 1995, down from 10.6% a year earlier. Lenders recognize the markets of the Northeast as somewhat riskier than the nation, with 10.4% the 1995 average cap rate for New England and the Middle Atlantic states, whereas the areas between the Appalachian Mountains and the Mississippi River show ACLI cap rates between 8.4% and 8.7%.
Even considering the more intensive transaction volumes, there still appear to be acquisition opportunities for entrepreneurial investors. Niche players who have the skills and the backing to tackle turnaround projects can find an ample supply of low cost office product in the market. Landauer recently looked at a sample of 127 office transactions booked in the first nine months of 1995, and found that 27% of them had sold for less than $50 psf, 38% had been struck in the $50 to $100 psf range and only 5% were over $200 psf.
Clearly, the ability to purchase office property at a substantial discount to replacement cost is quite common across the country. There are just too many buildings still at low occupancy levels and too many markets with rents below the feasibility level to foresee 1996 as a year for dramatic upward movement in prices. But that time is inexorably moving closer.
It is now generally accepted in the industry that a resumption of the construction cycle will herald the next broad step upward in office rents and values. Commerce Department data indicates an annualized 12.8% rise in construction volume for 1995, but total office building volume is still only half that of the 19841990 period. For the first time in years, though, speculative office projects are actually in development. Investment analysis for offices will once again need to factor meaningful supply additions into market projections.
Consequently, the extended decline in vacancy rates that has marked the 1991 - 1995 period will likely decelerate in 1996. For the 60 metropolitan markets analyzed in Landauer's Market Quality Ratings, vacancy dropped from 16% to 14.5% between the second quarters of 1994 and 1995. We expect the 1996 figures to show a less significant drop, and the national vacancy rate to stand at just above 13% as 1997 begins.
Furthermore, the gap between CBD and suburban vacancy rates should virtually disappear by the end of next year. Suburban markets have led the absorption recovery, and now enjoy an occupancy advantage over the nation's downtowns. But the construction revival will begin in the suburban markets as well. This will have the dual effect of increasing the competitive supply in the "edge cities" while very economical rents are available in good quality CBD offices in many areas. As the dynamics shift, simple extrapolations of the trends of the early '90s will fail to satisfactorily anticipate market behavior. The game is getting even more complicated.
Landauer's Momentum Index rankings reflect both the improvement in offices and the fact that wide variation in individual market quality typifies the industry. Our office Market Quality Ratings show 36 metropolitan markets earning ratings of MQR4 or better. This means that supply/demand conditions for 60% of U.S. markets should be favorable for office investments over the next five years.
Against the more positive background, however, there are more than a few areas of higher potential risk. Our map displaying the MQRs for all 60 metro areas indicates at least four geographic concentrations of comparative weakness: the Mid-Atlantic region from Stamford to Philadelphia; some of the large Great Lakes cities; pockets of residual difficulties in the Oil Patch; and California markets from Los Angeles to San Francisco. Also, there are a number of stubbornly distressed downtown markets where recovery will severely lag the performance of the overall MSA office economy.
The Landauer Forecast has, since 1986, presented our Momentum Index rankings of 24 of the nation's key office markets. This year's computation finds Orlando at the top of the list, for the fourth time in the past five years. Its market quality rating has improved to MQR2, which reflects the current strength of the market - a vacancy rate of 12.7%, below the national average - and its very strong growth prospects. The Orlando economy should grow 19,000 office jobs by the year 2000, an annual growth rate of 3%. Downtown actually boasts a slight advantage in occupancy versus the suburbs. Information technology firms, insurers and corporations are key demand generators.
Elsewhere in Florida, Tampa (MQR4) and Miami (MQR5) have maintained last year's ratings. Both markets have similar vacancy rates slightly above 15%, but Tampa's growth prospects appear superior. Though rents in Tampa have been firming, they remain too low to support new development. Office employment is forecast to expand 2.1% annually over the next five years, bringing suburban vacancies below 10% in early 1997 and setting the stage for a resumption of construction. Despite the excellent potential for growth in Latin American-related business, Miami has weaker prospects. Several thousand layoffs are in the works as a result of banking mergers, a specter haunting Miami's already battered downtown market.
The Southeast is also the regional home of two other markets with MQR2 ratings: Charlotte and Atlanta. The booming North Carolina economy has been fueled by Charlotte's emergence as one of the nation's key banking centers. Space is virtually impossible to find in the CBD due to the appetite of the financial institutions, and is scarce in the suburbs where occupancy is over 90%. At least six office projects are in the development pipeline, including one on a fast-track construction program. It may be time to note that absorption should be slowing in Charlotte in the second half of the '90s, and projections based upon recent history alone will likely prove overly opt1mist1c.
With the 1996 Olympics fast approaching, Atlanta has added 103,600 jobs in the 12 months ended July 1995, a 6% expansion which was the fastest of the nation's top 20 MSAs. Suburban vacancy dropped 3.6% over that period. Downtown occupancy has improved to 85%, sparked by a flock of short-term leases. This economy may be jolted by a sharp post-Olympics slowdown, but Landauer predicts a 2.8% average growth rate for office jobs over the next five years. Buckhead and North Fulton County are expected to be the major beneficiaries. The international exposure this summer will undoubtedly increase the already significant presence of foreign corporations and real estate investors in the Atlanta market.
Transaction activity is brisk in Washington, D.C. With an MSA vacancy rate just above 10% and occupancy in downtown Class A and B space at 92%, investor enthusiasm appears well justified. Shrinkage in Federal employment should surely be a cause for concern, but government tightening has also constrained one of the chief sources of new supply: the General Services Administration. The flood of lobbyists is unabated, and is not likely to ebb. Suburban areas such as Arlington, Tyson's Corner and Rockville should see rents surge, becoming key development nodes for the near future.
Prospects in the Middle Atlantic and southern New England cluster of markets are more dour. In this region we see the most severe effects of banking mergers, and 1996 will be a year when layoffs wash through the economy in a big way. Philadelphia faces layoffs at PNC Bank and Meridian Bancorp, and the MSA could be looking at net negative absorption over the short haul. With the exception of the more affluent Bucks County suburban markets, this looks like a risky year and Philadelphia's weak rating of MQR7 rejects only sluggish recovery through 2000.
Many will be disturbed, but not surprised, to find New York at the bottom of the Momentum Index ranking for the fourth consecutive year. Citywide employment was flat in 1995, and other sectors must make up for the 4,000 jobs being trimmed by the Chemical/ Chase Manhattan merger. New businesses are popping up in Manhattan, though, as the city exhibits a remarkable capacity to reinvent itself. New York, it turns out, is becoming one of the major commercial beneficiaries of the Internet due to an agglomeration of communications, entertainment, graphics arts and computer specialities. Investor interest remains active as evidenced by several office acquisitions by offshore entities and the multiple bids for Rockefeller Center. However, we do not see New York escaping double-digit vacancies until the early years of the 21st century, and must continue its MQR7 rating.
Net absorption of 2.8 million square feet in the Boston market has dropped both CBD and suburban vacancy rates below 10%. Investor confidence in the area has rebounded. Information services, management consulting and the mutual fund industry are the driving forces behind office demand, which Landauer forecasts will grow at 1.6% annually for the next five years. Like other markets Boston will be saddled with banking layoffs. But we expect to see improving market conditions generally, and a resumption of office construction in Framingham, Waltham and, possibly, in the Back Bay during 1996.
In the Midwest, there has been a sharp contrast between the stubbornly high vacancy in the Chicago CBD and the steep decline in available suburban space. Our rating of this MSA's office markets has risen to MQR4 based upon a projected gain of 67,000 office jobs by 2000, a growth rate of 1.9% annually. A narrowing rental differential between suburban space and the Chicago Loop will eventually correct the disparity in submarket absorption. For the time being, though, it's a tenant's market downtown.
Cincinnati retains its MQR4 rating on the strength of a 1.2% decline in metro office vacancy over the year, and the prospects of maintaining a 1.8% office employment growth rate over the next five years. Our outlook would be even more favorable, but for the volume of construction in the pipeline. Further vacancy declines may be hard to come by in such circumstances, and rents will likely stay in the $15 - $22 psf range.
Minneapolis is anchoring a remarkable performance for the Farm Belt states. The Twin Cities again carry an enviable MQR3 rating this year, with Kansas City (MQR3) and St. Louis (MQR4) stepping up a notch from last year. The most recent Federal Reserve "beige book" reveals business loan volume, a key indicator of economic expansion, growing at a healthy rate. Occupancy in all three cities is higher than the national average, and should remain so for at least the next two years. If there is a weakness here, it is in the downtown markets in the Missouri cities, where vacancies are still in the upper teens.
The statewide employment growth of 260,000 jobs in Texas in 1995 has finally propelled Dallas (MQR4) into the upper echelon of the 24 large Momentum Index markets. As we noted last year, high vacancies in the CBD are retarding its overall performance. Like New York, investor interest is on the rise, albeit at bottom-fishing prices that have seen downtown towers trade at less than $70 psf. Houston has not seen nearly as much enthusiasm, as its vacancies remain stuck above 20%. The other Texas markets included in our analysis, Austin, San Antonio and Fort Worth all are posting substantial occupancy gains, and have held their desirable MQRs over the year.
Denver and Phoenix were both battered early in the real estate downturn but have reached significant milestones in recovery by stepping up to MQR3 ratings in this year's Forecast. Investors who held patiently through the bad times are now bringing properties to market at prices in excess of $100 psf. Vacancies have dropped below the national average in both markets, and absorption prospects are excellent. Landauer projects new office employment of 33,000 in Denver and 25,000 in Phoenix through 2000.
Although not included in our annual Momentum Index listing, two smaller Western markets, Salt Lake City and Sacramento, deserve special mention. Both achieved MQR2 ratings, matching the top three cities on our Index, and are expected to expand their office employment base at a rate above 2.5% per year for the balance of the '90s.
Some of that growth is coming at the expense of the large California coastal cities. Although the statewide economy is now a year into recovery, both Los Angeles (MQR6) and San Francisco (MQR5) will have employment gains of less than 2% annually through the end of the decade. This will have a more beneficial effect in San Francisco's financial district where vacancy is now 10% and full floor space is scarce. In LA, entertainment industry demand is sparking submarket recoveries in Burbank and Century City. The concentration of Japanese holdings in California could make investment product available in 1996, keeping prices discounted.
In the Northwest, Portland and Seattle remain in good MQR standing this year. Portland's 9.8% vacancy is virtually identical in its downtown and suburbs. High technology firms are in love with this MSA, and corporate relocations and expansions have been the key to demand growth. We project office employment growth of 14,000 jobs in this 27-million-square-foot market through 2000, which will unquestionably lead to renewed construction.
Seattle's more diversified economy is coping fairly well with the ups and downs of Boeing, and Microsoft's launch of Windows 95 surely didn't hurt. By our estimate, net occupancy improved by 1.5 million square feet. We expect to see some upward pressure on Seattle's typical $20 psf rents since most of the office construction in the pipeline is owner-occupant oriented. REITs have been acquiring well-occupied properties at 12% cap rates in the Seattle area. It is likely that pricing will become somewhat richer in 1996, as more traditional purchasers explore the market.
The direction of both the user market (as measured by supply/demand balance) and the investor market (as measured by cap rates and investment flows) are headed in the same direction in 1996. These reinforcing trends imply a very active year in this sector, and a period of increasing optimism. The markets are still fairly fragile, it is true, and even a modest rise in construction will slow the pace of market improvement. On balance, though, we see the office sector on an upward path for the rest of the '90s. The comeback is underway.