Big Money Returns to Suburban Office Markets – A Guest Post from Llenrock Group Feb 25, 2015

This post from Eric Hawthorn is part of our Llenrock Group guest post series and originally appeared on the Llenrock Group blog.

Gateway markets and CBDs tend to get all the attention when it comes to the development or sales of office properties, but these high-profile markets and submarkets are not the only places one can find opportunities for office projects and transactions. Granted, highly constrained markets like Manhattan and San Francisco are seeing the highest sale prices/SF and most impressive leases signed, and in turn have drawn attention from some of the world’s most respected and powerful investors and developers. Today is an exciting time for office real estate: in recent years (i.e., since the recession), we have seen urban office cap rates compress substantially, new developments like Hudson Yards on Manhattan’s West Side have begun to rise–thanks to a huge influx of foreign and domestic investment capital–and aging office buildings like the Empire State Building have seen major capital improvements to attract the biggest and most desirable tenants through LEED certifications, new technology, and other features. But while top-tier CBDs are the only places that can command extremely high rents (as high as $100/SF or beyond if you’re in Manhattan), they are not the only places that office deals are taking place. Not anymore.

While REITs like SL Green (NYSE: SLG) and Empire State Realty Trust (NYSE: ESRT) may be focused on fully leased, class A trophies in one of the world’s top office markets, other entities like private equity firms and more speculative investors look elsewhere for more impressive returns. In some cases, office investors have been looking at opportunities in second-tier markets for better value-add opportunities. In other cases, and this is what I want to touch on today, investors have begun to explore and complete deals in what some have considered an investor’s no-man’s-land: the suburbs.

Make no mistake: the suburbs are far from dead. The single-family market may be recovering relatively slowly, and retail, hospitality, and office assets have seen higher vacancy rates in many suburban markets since the financial/real estate downturn. But it’s not as if suburbs’ entire populations have been sucked into the nearest big city–even if urban areas are growing more quickly these days. The point is that people still live in suburbs, businesses still operate in suburbs, and affluence still exists in many of these communities. Granted, since 2009 suburban office in most markets (not counting places like Silicon Valley, The Woodlands, and North Jersey’s NYC suburbs, of course) have underperformed in comparison to most other CRE asset types. It’s wrong to say that suburban office has fully recovered.

But this asset sub-class is recovering. Let’s look at some markets and their cap rates from 2014 (courtesy of Integra Realty Resource’s Viewpoint 2015).

• Austin, Texas (CBD: 6.25 / Suburban: 6.50)
• Boston, Mass. (CBD: 4.75 / Suburban: 6.25)
• Los Angeles, California (CBD: 6.50 / Suburban: 5.50)
• Chicago, Ill.: (CBD: 5.75 / Suburban: 7.50)
• Houston, Texas: (CBD: 7.50 / Suburban: 8.00)

Let’s examine these numbers a bit. In the case of fast-growing tech hub Austin, there’s little disparity in cap rates between CBD and suburban. Office demand is spreading widely in this market, pushing up values through the region. In other cities with high-demand CBDs, office tenants seem to be more concentrated geographically, keeping suburban office demand generally lower (and cap rates higher).

Now let’s look in particular at Chicago, whose CBD enjoys an enviable sub-6 cap rate for class A properties. Clearly there’s demand in its CBD, but what about its vast suburbs? Are office transactions taking place in its suburbs?

The answer is yes. Crain’s Chicago Business reports

Sales of suburban [Chicago] office buildings surged to $1 billion last year, the highest volume since the crash.

Suburban office sales rose almost 20 percent from about $865 million in 2013, the third straight year of rising sales but still only about half the 2007 peak of $2.09 billion, according to Chicago-based Jones Lang LaSalle. Thirty properties sold for an average of $124 per square foot, totals that also were post-crash highs.

Long story short, investors spent more money on Chicago’s suburban office deals last year than in any year since the financial crisis. While the $1.04 billion spent last year on a total of 30 transactions is only half the amount spent on 33 suburban Chicago office transactions in 2007, this is still a sign of substantial growth for this asset class.

And Chicago, a high-tier CRE market, is not an anomaly: Duke Realty. Corp (NYSE: DRE) recently announced its sale of more than a billion dollars’ worth of suburban office assets (in the Midwest and Southeast) to a JV led by alternative asset investor Starwood Capital Group. I discussed this huge portfolio transaction on Tuesday, when I made Duke Realty our Mensch of the Week. I suspect Starwood and company got a strong deal and will be able to improve and see respectable resale prices for many of these properties. Suburban office will never be as strong as office markets of most CBDs, but it will continue to recover in the near term, a prediction I base on all the real estate and econometric data I’ve seen. Just as major institutions bet on distressed single-family portfolios a couple years ago, value-minded investors are now looking at suburban office as our nation’s next “comeback kid.” But as with any asset class on the mend, suburban office’s steep discounts won’t last forever.

Expect many more suburban office deals in 2015 as investors scramble for last-minute bargains before these properties’ valuations rise.

Posted by: Raymond T. Cirz