There is not much good news around unless you are cash rich. Opportunities are ripening but many buyers are waiting for distress to worsen as Stephanie Schwartz-Driver reports

At the beginning of 2009, the US office market experienced its worst quarterly results since 2001, and there are no indications that the situation is going to improve any time soon. In fact, it seems likely that the worst is yet to come.

What is grim news for some investors, however, is good news for others. For those investors holding assets declining in value, those facing the need to refinance, and particularly those needing to sell, rising vacancy rates and declining values spell trouble. On the other hand, opportunistic investors and others with cash in their pockets are seeing potential.

Vacancy rates are on the rise nationally, although estimates vary. Colliers International pegged vacancy rates at the end of the first quarter of 2009 at 14.75%, up from 13.8% at year-end 2008. Grubb and Ellis, on the other hand, announced that vacancy rates had climbed as high as 15.6%, an increase of 80bps since the fourth quarter of 2008 and up 260bps from the fourth quarter of 2007, when vacancy rates had bottomed out. Colliers International notes that increases in space available for sub-lease contribute significantly to the rise in vacancy rates. Nationally, the total amount of space available for sublease rose to represent 11.1% of total vacant office space.

Rising vacancy rates tell only part of the story. Rents are also falling as leases roll over, points out Mike Acton, managing director and head of AEW Research in Boston, Massachusetts. "In any city, look at leases. A percentage is rolling over every year, and most are rolling down to the new market prices," he says. "And in almost all cases, rents are moving down relative to what was underwritten when the asset was acquired."

This leads right into the third part of the office story. The combination of a lower NOI in the property and tighter underwriting standards across financial services will reduce how much the lender will give by 20-30%.

"Pressure is increasing from the debt side for most owners," says Jason Mattox, chief administrative officer at Behringer Harvard, a real estate company investing domestically and internationally, based in Dallas, Texas. "There are creative ways of alleviating those problems." As an opportunistic investor, Behringer Harvard is seeing the bright side of a bad situation. "The current downturn creates challenges for legacy assets, but for an opportunistic buyer, the time is only ripening attractive transactions," Mattox says.

Pricing is an obstacle to even interested buyers back in current market conditions. It is challenging to achieve secure pricing in a market in which few assets are trading, and many of those that are moving are trading under distress, which is not really indicative of fair market value.

"Accuracy is a very tricky word," said Michael Giliberto, managing director, JP Morgan Asset Management, speaking about pricing during a recent meeting in New York City. "When trades are tainted with distress or the need for liquidity, that detracts from fair market value."

With very few comps available, investors are relying on other metrics and other methods of pricing, says Acton. "Everyone is talking as much as they can to create a mosaic of information," he says. "And you have to look at other things: at the real estate investment trusts (REIT) market or at corporate bonds."

Difficulty in assessing value is also making it even harder to find financing. "The most important metric right now is the cost of borrowing money, if you can find it," says Acton. "The equity yield has to make sense against the debt."

In addition to constraining the availability of financing, insecurity about valuations is creating a gap between buyers and sellers, says Mattox. "There is a lot of capital sitting around. It is a question of closing the bid-ask spread," as sellers hold fast to their 2007 hopes.

Similarly, buyers are waiting for the distress to worsen, and this might not play out in the way they think, suggests Jon Southard, director of forecasting at CBRE Torto Wheaton Research.

"A lot of people are waiting for a shake-out. This will affect prices but also will encourage the first wave of investors looking for distressed assets," says Southard. "There will be more distressed sales - but I worry that the shake-out will not be as large as some buyers hope."

"It could be a steadily growing stream rather than a wave," points out Southard. The question is whether a non-distressed market will develop on top of that stream, or whether investors will remain on the sidelines, waiting for distress to clear the system. Which alternative prevails depends on several factors, including what will happen to the banks and financing, and whether it will take so long for distress to clear that investors can no longer wait for the end of distress.

"There is a negative story: a wave of defaults will be a catalyst to shock prices down," says Southard. "But there is also a positive story: outside of real estate, other sectors improve so much that higher cap rates and prospective IRRs look better and attract investors to commercial real estate." In this view, investors could react to the way that spreads on other classes are coming down and be pushed into office, bringing capital in that direction. Southard pragmatically declines to predict which outcome will prevail.

Acton agrees that repricing is definitely occurring, but it is happening slowly. He points out that so many loans were floating rate on LIBOR. Because LIBOR is so low now, debt costs are also very low, maybe 2-3%. This low rate means that they are coverable, despite rising vacancy rates, unless a building is very impaired. "This pushes the day of reckoning out," says Acton. "Everyone is getting prepared for a long duration."

Envisioning recovery, "it is easy to get ahead of ourselves", warns Southard. "The first step is seeing some positive job growth, recovery in fundamentals, and recovery in capital markets." None of these is immediately forthcoming.

AEW sees a gloomy scenario unfolding. The firm predicts that peak to trough unemployment will fall around 5%, and that vacancy rates will go higher than they did in the early 1990s, not because of oversupply but because of job losses. The firm is expecting vacancy rates to rise nationally to around 20%, an all-time high, and that it will take a long time for them to move back down to a normal, healthy 10-12%. Acton does not expect to see decent job figures until the second quarter
of 2010.

Economist Christian Menegatti, head of global economic research at RGE Monitor, gives a similarly pessimistic view of the US employment outlook. There have been more than 7.2m jobs lost since the downturn began. He expects unemployment to reach 10% by the end of the summer and 10.5% by the end of 2009, peaking above 11% in 2011.

Offering one bright spark on the employment front, Menegatti notes that historically the peak of initial unemployment claims is associated with the end of the recession. While 650,000 jobs were lost in March 2009, only 540,000 jobs were lost in April, 345,000 in May, and 467,000 in June. While he is reluctant to point to an end to the recession, he is confident in saying that contraction is at least slowing.

The loss of financial services jobs has been hard for the office sector, because this form of employment is very office intensive. Despite the loss of jobs in New York, however, the metropolitan area was one of only three major US markets to register less than 10% vacancy rates, according to the Grubb and Ellis report; the others are Washington DC at 9.9% and Boston at 9.4%. (Contrast this with Phoenix, which has office vacancy rates approaching 25%.) However, sublease figures tell a different story. In New York City, according to Colliers, space available for sublease accounts for 29% of vacancies; in Fairfield County/ Greenwich, Connecticut, which boomed with the hedge fund industry, 20% of vacant office space is that available for sub-lease.

"New York is a tough story: it is hard to replace that kind of finance employment," says Acton. "But New York has been counted out a lot and has always bounced back."

"It is difficult to see a lot of positive news in the short term," agree Mattox. "With the debt situation and recessionary signs, we have some distance to go." However, he notes that "there are always some people who take the contrarian view, seeing once-in-a-lifetime buying opportunities."

Behringer Harvard is looking for "high-quality properties with ownership challenges", says Mattox. The firm is focusing on coastal markets, places where there has been solid, long-term performance. "We're looking to long-term fundamentals," he explains: multi-tenant properties, with a diverse tenant base, in high-barrier-to-entry markets that do not have too many property-level challenges to work through. One example of a market that might interest the firm, says Mattox, is Washington, DC, "which still has tremendous demand drivers in government and defence".

Regionally, the coasts have suffered greater declines than the South or the Midwest, according to an analysis by IPD, the global real estate performance analysis and benchmarking specialist. The West coast has seen declines in capital growth in the year ending December 2008, coming in at -13%, and the East coast around -12%.

But although the coasts have been hit harder in the downturn, when it comes to 10-year average returns, Washington, DC, New York, and Los Angeles presented returns significantly above average - about 2-3%. On the other hand, Dallas, Houston, Atlanta, Miami, San Francisco, and Phoenix fell well below average in returns; in addition there was incredible volatility in some markets, especially Phoenix.

The bad news for the office sector was that nationally it fared the worst of all property investment types, with capital growth for 2008 of -12.8% (compared with residential at -12.2%, industrial at -11.7%, and retail at -11.4%).

While both central business districts (CBD) and suburban and regional office markets have been hammered in this downturn, CBDs have offered outperformance in seven out of the past 10 years, according to IPD.

Interestingly, it might be in suburban and retail sectors where more activity is taking place now, notes Southard. There has been interest from international investors in US commercial property, including from some Middle Eastern sovereign wealth funds, some German banks, and some Asian investors, but "interest is the key word at this point".
Based on past history, such investors focus on downtown, high-rise properties.

However, what action there is, is taking place in a different sector, Southard says. US buyers - smaller investors including lawyers, doctors, or dentists - are looking at small, largely suburban office properties, and community, local, and regional banks are still actively financing that size of deal.

In the short term, the US government stimulus spending is going to determine growth areas, notes Acton, with most growth taking place where the stimulus money is directed. In terms of business sectors, this means areas such as education, healthcare, infrastructure, and government services. "These generic business services are not as office-intensive in the way the lost financial services jobs were," Acton points out.

Geographically, the government tried as much as possible to spread the stimulus spending around the country, with per capita spending rather uniform across the states. However, large metropolitan areas stand to benefit more, simply because that is where populations are concentrated.