4 Questions Office Investors Should Be Asking

Four Questions Office Investors Should Be Asking

The office sector is undergoing a transformation amid dramatic changes in tenant demand, slow growth, and more efficient use of space. PrivcapRE spoke to professionals from Clarion Partners, Reis, Rockspring, and Shorenstein about their outlook for the office sector, and the four questions investors should be asking.

#1. Are valuations ahead of fundamentals in core U.S. markets?

When central business district offices can trade hands for sub-4-percent cap rates, it’s time to ask whether office property valuations are ahead of fundamentals.

The reality is complicated, says David Gilbert, chief investment officer of Clarion Partners. “Values are nothing more than the intersection of capital flows, rents, and fundamentals, and it’s impossible to disaggregate them.” But while the impact of capital flows into, and within, the U.S. are being felt in an array of markets, with aggressive pricing in some areas, it doesn’t mean fundamentals are lagging behind.

Glenn Shannon, president of Shorenstein, says demand for U.S. core office has never been stronger and isn’t going to weaken soon, because it represents good value relative to other investment options. In a few key markets, such as New York, Boston, San Francisco, and Silicon Valley, Shannon says there are “some very astute investors selectively making the bet that we are going to have very significant rental growth [in the office sector] over the next three to five years.” Given the track records of the investors and the amount of equity being committed to the markets, Shannon says, “you have to take seriously the possibility that their investment thesis will prove correct.”

For Shorenstein, the focus is broader. “We believe there are going to be 15 to 20 distinct [U.S.] office markets and submarkets that will outperform,” he says, “because they offer a confluence of factors that produce a vibrant live-work-play environment that will attract the employee base that companies are seeking.”

Gilbert agrees that the pace of foreign capital flows into the U.S. is “significant,” but it isn’t all going to the top five markets of New York, Los Angeles, San Francisco, Washington, D.C., and Boston. “It’s surprising how broad the destinations of foreign capital flows have been, including Houston, Atlanta, Miami, and Seattle,” he says.

The challenge for the top five markets is expected to be the pace of economic growth, according to Gilbert. “Much of the rental growth we’ve seen is a recovery from cyclical lows, and that’s over. “And cap rates are also unlikely to decline further. From here on in, it will be about the impact that fundamentals have on rental growth.”

#2. Is new supply a concern in core office markets? 

The topic of supply is critical to any conversation about valuations and fundamentals. Given the slow pace of recovery in Europe and the U.S., there’s little concern about an oversupply of new offices and a subsequent rise in vacancy rates and fall in rents, says Reis senior economist Ryan Severino. But there are pockets of development in the U.S. to be aware of.

“A lot of the construction that’s occurring

[in the U.S.] right now still requires a significant amount of pre-leasing in order for the construction financing to become available, probably at least 40 percent to 50 percent, if not a greater extent than that,” says Severino, adding that the industry is “a ways removed from seeing construction come back in any meaningful fashion.”

Gilbert agrees, saying there is a “narrow list” of markets where new office construction makes economic sense. Where development is occurring, it is clustered in submarkets such as New York’s Hudson Yards and the downtown World Trade Center area. San Francisco and Houston have also been home to significant new development, Gilbert says, but these markets have seen exceptional demand and pre-leasing as well.

With this supply-and-demand profile, in the next four to five years, U.S. office vacancies are likely to fall to 14 percent from 17 percent, and rent growth to accelerate to 3.5 percent or 4 percent, Severino says. “That’s not, in the broader context of the office market, the healthiest market environment that I can imagine, but it’s certainly a lot better than where we’ve been over the last five to six years.”

For Europe, the supply story is much more muted, says Rockspring Property Investment Managers’ head of research, Jose-Luis Pellicer, with a lack of financing and stricter planning systems constraining new development.

“The European banks, contrary to the U.S., are still clearing their balance sheets, so any development has to be financed predominantly through equity, and the return is far too low,” says Pellicer. That fact, though, makes Europe an interesting investment option.

“Never forget that the fundamental difference between Europe and U.S. is the supply side,” Pellicer says. “Planning in Europe is far more stringent than the U.S., so you don’t need to be consistently investing in assets to keep them competitive. U.S. investors looking at Europe see low cap rates and low economic growth, but they’re missing a crucial element, which is the structural lack of new supply
—and that makes investments far safer.”

#3. Is it all about the tech industry?

The technology, advertising, media, and information technology (TAMI) industries are shaping demand and rent dynamics in certain office submarkets across the U.S. and Europe. By taking office space in formerly staid or neglected areas, they are transforming unloved markets into cool, hip places to work. And by demanding different types of office space—largely open-plan offices in existing buildings—these TAMI industries are forcing landlords to change the way they look at their assets.

“It’s about the ‘next big thing’ in business, and targeting businesses that are willing to pay a premium to be in the very best locations,” says Pellicer. During the financial boom, the next big thing was hedge funds. Today it’s the tech sector, Pellicer says, but he warns that not all tech firms are created equal. “Tech startups…are not making the high revenues and revenue growth that the likes of Amazon and Google are.”

Gilbert agrees that the high prices being achieved in core U.S. markets could result in a “wake-up call” regarding affordability and occupancy costs, pushing tenants into other areas.

“For Google and Salesforce and the like, they want unique high-quality real estate, and occupancy costs are not their top concern,” Gilbert says. “But for niche firms that are growing fast, there’s an affordability issue, and we are seeing it in New York’s Midtown South, where rents three years ago were in the region of $50 a square foot.

“When those leases come up for renewal and the new rent is $80 a square foot, what will those tenants do?” asks Gilbert. They’re going to go downtown, to Long Island City, to Brooklyn and further west—to areas that still allow them access to talent but provide cheaper rents.”

This new pattern of tenant demand is shaping investment strategies at Clarion and Shorenstein. Gilbert says it isn’t just tech firms eyeing new markets and submarkets. Finance, insurance, and real estate industries are also looking to move jobs to “lower-cost places like Dallas, Phoenix, Salt Lake, Austin, Raleigh—and that’s a function of cost pressures and seeking high-quality places for employees to live.”

Shannon says the “demand recovery [in U.S. office] has clearly spread beyond technology, media, and other creative uses” with increased occupancy and demand across all industries, “including expansions and extensions by more traditional office tenants who had previously been reluctant to take on more space.”

For Shannon, success in the office sector is all about differentiating the product. Today that often means more efficient, and flexible, floor plates, higher ceilings, increased light and air flow, and in the case of older offices, “an authentic feel.” However, redeveloping older office space is not for the faint of heart, Shannon says. “Some older properties, notwithstanding the amount of capital you pour into them, will never be sufficiently distinctive or efficient to command premium rents,” Shannon says. “And the costs of these types of renovations can be difficult to estimate and hard to control. Mistakes will be made, I’m afraid, by investors who try to play into the creative office trend with the wrong projects.”

Gilbert says investors can’t ignore the dramatic growth in the energy sector. “I don’t think there was a headline in the world that could have predicted the U.S. would be energy independent in the space of just a few years,” he says. “In terms of real estate, the number one problem for energy firms is how to attract talent, so occupancy costs are low on their list of issues. It’s about occupying real estate assets that allow them to capture talent.”

#4. Should landlords be providing offices with only open-plan, collaborative spaces? 

Reis’ Ryan Severino says the answer is no, pointing to recent studies that indicate a decrease in worker productivity when traditional service and finance firms convert to open-plan office layouts. For TAMI industries, open-plan is here to stay. For more traditional industries, such as law firms, banks, and real estate service firms, Severino says it could end up being

an “unmitigated disaster,” and there could be a backlash against this style of workplace.

“If someone comes from an industry that’s not used to this format, the research pretty conclusively shows that it actually decreases productivity,” he says. “Instead of this sort of massive productivity boost that [office] landlords have certainly been touting, the empirical evidence fairly conclusively shows that the opposite occurs.”

The shift to open-plan offices is due, in part, to a slack labor market and cost pressures resulting from the recession. “And so I think that this is a temporary response to very unique circumstances,” he says. “Now, there are some industries that I think will probably stick with this format, but I think there a lot that are trying it out right now, and—I would say this is just some of my own anecdotes—the more I hear about business and professional services firms that haven’t used this space trying it out, it just ends up being an unmitigated disaster.”