Office Investment Risks Mount

Office landlords can't help but smile. The national vacancy rate has declined for 11 straight quarters, registering 13.1% at the end of March. Manhattan-based real estate research firm Reis also reports that average asking rents have been trending upwards, rising from $25.06 to $26.70 per sq. ft. over the 12-month period ending in March.

The healthy state of the market is a stark contrast from the 18.3% vacancy rate recorded in June 2003, when the office sector bottomed out. But after a long successful run, Reis chief economist Dr. Sam Chandan believes that office market momentum is starting to weaken.

“There are definitely some warning signs for office fundamentals,” says Chandan. “Slower job growth in particular is already translating into weaker net absorption, and the big rent gains are concentrated in just a few markets,” he says. Monthly job growth in the U.S. averaged 129,000 during the first four months of this year, down from an average of 189,000 during the same period in 2006.

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Self-Storage REITs Feeling the Pinch

In self-storage markets, scattered signs hint of a slowdown. In cities such as Columbus, Ohio, customers can get the first month's rent for $1. Shares of the average self-storage REIT lost 3.4% in the first four months of 2007, according to the FTSE NAREIT Equity index. With housing sales falling, some investors worry that fewer homeowners will be storing lawnmowers and computers.

So is self-storage about to suffer a crash? Probably not. While the industry has little data on total vacancies, some markets clearly remain strong. Customers searching the Internet can find few discounts in cities such as San Diego and Boston. Overall, the national picture appears mixed, say industry experts.

Analysts feel few markets suffer from saturation. “Some companies report that demand is a bit weak, but others are showing decent same-store sales,” says John Sheehan, a securities analyst for brokerage A.G. Edwards & Sons in St. Louis.

Extra Space Storage Inc., a REIT in Salt Lake City, is typical of owners that are reporting so-so results. The company expects its net operating income to grow about 5% this year. That is down around a percentage point from the results of 2005 and 2006. “After two strong years, we are seeing a slight slowdown in 2007,” confirms Kent Christensen, executive vice president of Extra Space.

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A Growing Office Empire

As one of the nation's fastest growing suburban office markets, Ontario, Calif. is teeming with new development. With a booming local economy, cranes are rising all over this Inland Empire city of 171,000 located 35 miles east of Los Angeles.

Grubb & Ellis reports that Ontario's office market contained 3.7 million sq. ft. of vacant space as of mid-May with another 1.8 million sq. ft. of new space under development. Over the next two decades, roughly 1 million sq. ft. of new office space is expected to come on line annually. While some projects may never get completed, even conservative estimates point to a torrent of new supply.

“Speaking generally about the Inland Empire office market, we believe that the onslaught of new office construction will continue to drive vacancies higher,” says Suzanne Mulvee, research analyst at Boston-based Property & Portfolio Research. Mulvee expects 5 million sq. ft. of new office space to be completed through the end of 2008, pushing Inland Empire office vacancy up from 10% at midyear to 17% by the end of 2008.

“I think many developers may be getting ahead of themselves out here,” says Chris Atkinson, vice president of Bates Co., a locally based development firm. “If you saturate the market with supply, you will stagnate future growth.” Bates Co. has developed more than 500,000 sq. ft. of office projects in and around Ontario. Another 400,000 sq. ft. of local office projects are slated for completion by 2010.

Ontario's strong job market has the potential to absorb the thick pipeline as it hits the market in coming years. The Inland Empire added 48,150 new jobs in 2006, which helped the economy grow 3.9% over 2005. Meanwhile, the Inland Empire's local unemployment rate registered 4.6% in 2006, lower than the national rate of 5%.

The healthy labor market has helped the office market to an extent. However, while 29,477 sq. ft. of office space was absorbed in the first quarter, another 126,000 sq. ft. of new completions also came on line, driving vacancy to 12.1% from 9.8% the previous quarter, according to CB Richard Ellis. CBRE expects Ontario office vacancy to rise again during the second quarter when another 149,466 sq. ft. hits the market.

Mary Jane Olhasso, director of the Ontario Economic Development Corp., is confident that tenant demand will catch up with mounting supply. “We've seen so much [economic] growth in Ontario over the past few years, and the pace should continue,” says Olhasso.

One developer says that his speculative office project is already drawing interest from tenants. Jack Hileman, partner and president of The Hileman Co., is building a 150,000 sq. ft. office building in Ontario. “Plenty of companies are talking to us about this project, and many of them are considering a move from the Los Angeles or Orange County area,” says Hileman. His $40 million Waterside Center II project will be completed next July.

In 2006, the U.S. Census Bureau identified the Inland Empire as the 14th largest metropolitan area in the nation by population, up from the 35th largest metro area in 2000. Southern California economist John Husing believes the greater Ontario region still needs space for its growing employment base.

“[Ontario] is a huge population base and huge economy that is growing faster than every other part of southern California,” says Husing, vice president of independent consulting firm Economics & Politics Inc. He projects that the region will add 37,200 jobs in 2007, down from the 48,150 added in 2006. “Southern California's edge community economies have always grown up in waves.”

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Office Towers Sprout

In the early 1990s, investment in Toronto commercial real estate development was more or less stagnant, except for an uninterrupted ripple of high-rise condo towers on the city's waterfront and throughout the downtown core.

These days, however, the city is in the midst of a revival, with three new towers encompassing 3.1 million sq. ft. under construction a few blocks apart in Toronto's CBD.

The timing could hardly be better, with the vacancy rate for Class-A downtown office space a projected 6.8% in the second quarter, virtually unchanged from the same period last year, according to CB Richard Ellis.

Institutional real estate equity firm Halcyon Real Estate Partners LP, based in Boston, owns a 20% stake in the 32-story, $250 million Telus Tower near the waterfront. (Prices are in Canadiandollars unless otherwise noted).

Halcyon is developing the 780,000 sq. ft. tower in a joint venture with Toronto-based Menkes Developments Ltd. and Hospitals of Ontario Pension Plan (HOOPP). Telus, a Vancouver national telecommunications company, will occupy about 440,000 sq. ft., or 60% of the total rentable area.

Why Toronto? “It's the fourth or fifth largest metropolitan market in North America,” says Martin Zieff, a Halcyon co-partner. “It has a very diverse and dynamic economy with great demographics, a strong economy, and a broadly based real estate market. It's a positive opportunity.” The market also is a magnet for global capital and historically has provided attractive yields.

The $400 million, 1.2 million sq. ft. 43-story RBC Centre is being developed by Toronto-based The Cadillac Fairview Corp. for lead tenants RBC Financial Group and RBC Dexia Investor Services. While most of the space will be taken by these tenants, over the past few months other corporations have signed leases accounting for 98.5% of the leasable space.

The $290 million, 50-story Bay Adelaide Centre also has landed its lead tenant. KPMG, an audit, tax and advisory firm signed up for 250,000 sq. ft. of the 1.2 million sq. ft. structure. The tower is the first of three phases of a combined 2.6 million sq. ft. on two city blocks being developed by Brookfield Properties Corp.

Previous owners had built six unfinished stories of the elevator shaft and an 1,100-stall underground parking garage, when they pulled the plug during the 1991 real estate market meltdown. The abandoned project, known locally as “the stump,” was demolished in 2006.

All three new buildings were designed to obtain the silver Leadership in Energy and Environmental Design (LEED) certification standards upon completion in 2009. LEED is the North American standard for the design and construction of environmentally sustainable buildings.

Betting on Toronto

In addition to Telus Tower, Halcyon has invested an undisclosed amount in the $85 million Lumiere, a 30-story, 330-unit joint project developed by Menkes and Lifetime Urban Development near the financial district and slated for completion in early 2010.

The fund also holds an undisclosed interest in the glamorous $325 million Four Seasons Residences under construction in midtown. The 265-room hotel and 125-condo project sits around the corner from the city's answer to Park Avenue.

Halcyon Ventures LP was formed in December 2004 by and Zieff and Mark Potter, whose initial fund closed with equity commitments of (US) $152 million. Its Halcyon Real Estate Partners Master Fund LLC closed in July 2006 with commitments of (US) $303 million and has since grown to (US) $350 million, according to Zieff.

“Toronto offered attractive yields relative to comparable cities in North America,” says Zieff. “We could buy buildings for half the replacement cost in Toronto before the office market recovered in the early 2000s, so there is attractive arbitrage on a relative basis. Toronto has been a great thing for our firm.”

It has apparently been a great thing for other firms as well. The City of Toronto released a report prepared by Standard & Poor's in May stating that there were 83 high-rise buildings under construction in Toronto that month — far more than Boston, San Francisco, Atlanta, Miami, and Chicago, and surpassed only by 124 buildings in New York.

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Office Market Lifts Spirits of St. Louis

Optimism in the St. Louis office market is as palpable as the energy that enveloped the city when the Cardinals won the 2006 World Series. Riding that wave of euphoria, THF Realty last September sold the 16-story Plaza in Clayton building to KBS Real Estate Investment Trust for $93.2 million. The deal set a record of $290 per sq. ft. for a Class-A building in the St. Louis market.

The whopper of a deal occurred in the midst of a 12-month period ending March 31 in which the market tallied a robust $829 million in office investment sales, according to New York-based Real Capital Analytics. “A lot of owners of real estate are trying to capitalize on this level of activity,” observes Chris Fox, who is managing director of brokerage for Gateway Commercial/Cushman & Wakefield. “They recognize that at some point, it has to come to an end.”

But perhaps the run isn't over just yet. The Gateway to the West is generally insulated from the more severe ebbs and flows seen in the larger markets, explains Fox, who brokered the Plaza sale for its owner, THF Realty, a St. Louis developer. “What's really pushed investors to such a high level in St. Louis is the competition for properties in markets like Chicago, New York or Los Angeles.” The downtown office market, which has lagged behind the rest of the metro area, is starting to see signs of a resurgence, with new residential, restaurants, retail and office.

The largest buyers of office properties in St. Louis are private investors that raise both public and private capital to invest in real estate as well as pension funds. KBS REIT of Newport Beach, Calif., for example, is a non-traded REIT that taps into the wealth of private investors. “There's a lot of institutional investment going on as those entities continue to allocate a substantial amount of funds to commercial real estate, which is a big driver in St. Louis,” says Fox.

The increased activity occurred despite limited demand for office space and weak rents in the first quarter of 2007, according to Reis, which reported a metro vacancy rate of 15.2%, down 130 basis points from the first quarter of 2006.

As cap rates compress across the nation, investors are turning to the Gateway City for higher returns. “It's not a growing city like Vegas or Phoenix, but it is steady,” says Danny Prosky, managing director of healthcare properties for Santa Ana, Calif.-based Triple Net Properties LLC.

In June, Triple Net Properties purchased a 315,000 sq. ft. headquarters building for Express Scripts from Northpark Partners ESI for an undisclosed amount. The build-to-suit facility, located on the campus of the University of Missouri-St. Louis, is leased to Express Scripts, a Fortune 1000 healthcare company.

Triple Net's cap rate on the transaction was 7.3% — on par with St. Louis' average office cap rate for the first quarter of 7.4%, but high compared with the U.S. average of 6.9%, reports Real Capital Analytics. Prosky says if Express Scripts opts to move forward with a second building on the site as planned, Triple Net will seek to snap up that property as well. “Because of cap-rate compression elsewhere, places like St. Louis are nice to invest,” Prosky says.

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