America’s swathes of sprawling suburban offices face a future of vacancy and obsolescence. But some innovative investors are breathing life into the unloved market, writes Christopher O’Dea
In the empty parking bays and shuttered conference rooms of suburban office campuses across the US, property investment managers are working to transform potentially obsolete space into the creative environments employers demand today. Some are even reconfiguring land and buildings to create strategically located ‘superparks’ in a bid to compete with the allure of creative space in urban centres.
It is a long-running story. Amid the ongoing demand for most types of US property, suburban office space is often overlooked. Owners of suburban offices have struggled to attract occupiers in a world of urban amenities, mass transit and environmentally friendly, creative working areas. Parking lots, sculpted greenery and low-slung private campuses are fast being replaced.
The story is familiar. Employment growth in the so-called TAMI – technology, advertising, media and information – sectors and a growing millennial workforce accustomed to urban life have prompted companies to relocate many jobs to what is now called creative space, characterised by high ceilings, collaborative working areas and natural light. Most of that space is found in city centres.
Those changes have progressed so far that as much as 22% of US suburban office space is in some stage of obsolescence, a situation that means that, in the 50 largest US metropolitan markets, as much as 1bn sqft of space needs investment ranging from prudent retrofitting to complete repurposing in order to become competitive in today’s market. That is according to a detailed study of the state of suburban office space by the research team at Newmark Grubb Knight Frank (NGKF), which studied six quantifiable factors for space in a key suburban sub-market of five major metro areas in the US (figure 1). The result is a set of metrics about what makes a building obsolete.
The research also provides a sort of road map for institutional investors to navigate the extensive tracts of suburban office property, which often comprise multiple buildings sprawled across dozens of acres interspersed with parking lots, landscaping and road networks. In areas that became bastions of such corporate campuses, such as Northern New Jersey, vacancy rates on older office stock are hovering around 25%.
It is a handy tool, because although much suburban office stock will never become prime real estate, much of it can be repurposed. But doing so is perhaps the ultimate challenge for value-added property investors. Bringing property built in the 1970s and 1980s up to today’s standards requires not just a new exterior skin and HVAC system but also the creativity to envision new possibilities for both buildings and land. It also requires the ability – and tenacity – to complete projects that might require zoning changes to allow new uses of land, or transforming discarded corporate labs into hip environments to attract tech tenants.
These challenges could also be opportunities for institutional investors that can take a long view and are willing to find hands-on operators with expertise in zoning changes and repurposing. Investors say some recent transactions have taken place at cap rates of between 6% and 7%, ranging from buildings being completely renovated down to the frame to new class-A property. Colliers International says tenants were paying an 11% premium for class-A space in New Jersey in the third quarter of 2015 – as long as the space met current tenant criteria.
Those criteria mark the dividing line between suburban office property that could make an attractive investment and those likely to remain mired in obsolescence. NGKF defines obsolescence as a decline in the economic value of an office building resulting from net operating income being insufficient to provide an adequate, market-competitive yield after paying operating costs and costs related to land.
The good news is that some factors that contribute to the obsolescence of suburban office are curable, says Bethany Schneider, senior research analyst at NGKF. “There are some factors that could allow properties to regain a competitive position,” she says. The three major curable factors are amenities, either in the building or in an immediately adjacent neighbourhood, the age of the building, which largely determines the nature and extent of renovations required, and the parking ratio at the property.
While money can resolve these challenges, Schneider says, a case-by-case exercise is required to determine whether it makes financial sense to upgrade a building to today’s standards. Some buildings are saddled with features that make them incurably obsolete – primarily location, total size and dimensions of the floor plate. Suburban office buildings far from urban cores, if there is no prospect of a nearby transit station or new highway exits, are unlikely to achieve market-average rents as leases roll over. The standards are tight; the NGKF study found that acceptable suburban locations were those within a half-mile of mass transit stations or which enjoyed premier highway access. Many buildings will no make the cut. “There are thousands of office buildings that are partially leased but not able to attract new tenancy due to physical or locational deficiencies,” the NGKF study concludes.
Owners have struggled against employment and obsolescence factors in their efforts to bring the occupancy rate on suburban office property up to levels that would justify rent increases. The last several downturns have exacerbated the difficulty of overcoming those factors, leaving much suburban office property to start each recovery phase from a lower base, says Tim Wang, director and head of investment research at Clarion Partners. “Suburban office property is usually the first to be hurt, and the last to recover,” says Wang.
In general, says Wang, occupancy in central business districts in primary US markets tends to be above 88%. Suburban property occupancy rates tend to be near 80%, or a bit higher, but can fall sharply in downturns, with some buildings plummeting to 50% vacancy. When economic growth resumes, those properties struggle to replace lost tenants at rent levels equivalent to those in place with departing occupiers – or even lower in some cases – and will often achieve occupancy levels in the low-80% range. “But that’s still not enough to get over the hurdle,” says Wang. “Owners do not have much leverage to raise rents.”
This is because the tidal surge of millennial employment preferences is so powerful, Wang says. “For companies in the TAMI fields, the only edge is talent,” he explains. And right now, those jobs – and the demand for space to house those employees – is concentrated in cities. “It’s a matter of competitive advantage,” he says, pointing to GE’s decision to abandon the suburban Connecticut headquarters it has occupied since 1974 in favour of sharp new creative space in Boston’s downtown Seaport District. “GE needs to recruit talent, and they need access to universities like Massachusetts Institute of Technology to attract PHDs that can help the company with the cutting-edge technology they need to grow.”
While companies are moving front office, engineering and strategic jobs to urban and knowledge centres, Wang says, many are taking advantage of available information and customer-service technology to move back-office and support roles to new locations; however, they are often skipping over existing suburban office space in favour of remote new locations like Dallas, Phoenix and Salt Lake City.
Such locations have been rendered profitable by technology – data processing and storage, call centres and many similar functions can be carried out in locations where labour and space costs are significantly lower than prevailing levels in traditional suburban markets. Employees are attracted to those locations for reasons such as outdoor recreational access, larger homes and residential plots, and lower taxes and living costs. While these factors differ from those pulling people to central cities, they are just as powerful as an employment incentive.
All that makes the selection of suburban office property for investment purposes more challenging, says Wang. Nevertheless, suburban office space today “could present potentially attractive opportunities,” he says. The investment case is that such property can be acquired on a very low-cost basis and much higher cap rates using highly accretive financing. The key is to identify better performing suburban locations that are transit-oriented and have access to amenities.
Capitalising on opportunities to reposition suburban property requires careful asset selection and patient execution of often detailed strategies to reconfigure and retitle underlying land parcels and obtain zoning changes to allow construction of new buildings – often of a type different to what previously stood on the land. One of the most creative approaches is being taken by Normandy Real Estate Partners, an institutional property investment and management firm based in Morristown, New Jersey. Its current investment vehicle, Normandy Real Estate Fund III, LP has over $1bn of purchasing power.
Normandy focuses primarily on value-added office investments in three of the largest markets in the US: the New York/New Jersey/Connecticut Tri-State area; the Washington DC Metro market and the Greater Boston Metro area. One of Normandy’s principal projects is Center 128, a 41 acre superpark comprising 1.8m sqft of space in Needham, Massachusetts, a suburb close to Boston along the Route 128 technology corridor that presaged Silicon Valley.
The project illustrates NGKF’s conclusion that location is critical. “In the suburban Boston office market, inside or along Route 128, is really the place to be,” says Jeffrey Gronning, a founder and partner of Normandy. The project encompasses east and west sections. The west section features 850,000sqft that was assembled by acquiring five single-story class-C buildings. Normandy disposed of two, and obtained permission from the town of Needham to retitle a new parcel made up of the remaining three buildings and another parcel of contiguous land. Some of the land was sold to a hotel developer that built a Marriott Residence Inn. The principal building to date in the west section is a 250,000sqft class-A headquarters built to the specifications of the occupier, digital travel company TripAdvisor, which signed a 15-year lease including an option to expand into an additional 150,000sqft in the superpark. The east section centres on renovating three class-C buildings into class-A loft-style creative space.
Institutional investors are taking note of the opportunities in the suburban office sector. In June 2015, the TripAdvisor building was sold to US Realty, a net-lease investor, at a cap rate of approximately 6.75%, says Gronning. The rate was lower than expected, Gronning adds, although slightly higher than some recent transactions in the 5.99% to 6.1% range in New Jersey. “When you create these long-term credit leases, there’s institutional investor desire for these assets,” he says.
While much suburban office property faces some form of obsolescence, there is enough investor interest in occupied properties to keep cap rates for class-A space between 6% and 8%, according to CBRE Research. Investment transaction volume in the New Jersey office market reached $2.5bn last year, Colliers says, surpassing 2014 and marking the highest volume since the $2.6bn recorded in 2007. The largest transaction in the third quarter traded at a 7.7% cap rate, Colliers says, while two large transactions in the fourth quarter took place at cap rates between 7% and 8%. Cap rates of 8% or more prevail in class-B space, buildings between 10 and 20 years old, with systems and technological capacity that is functional but not best-in-class and high-quality but outdated finishes. Much of this property is in the eastern half of the US, where old-style campuses prevail.
“Recently we have seen cap rates trending down a bit,” says Peter DiCorpo, president of the US managed accounts group at CBRE Global Investors. The attraction of suburban office compared to urban infill is yield, offering about a 150bps advantage and solid cash flow, he adds. In the current market it is possible to buy fundamentally sound suburban assets at prices low enough that the project is still 15% to 20% below replacement cost after making improvements.
But the key is selectivity, DiCorpo adds. “You need to be in the top corridors or close to amenities in buildings with good bones.” As for CBRE Global Investors, “we are looking at a very few markets,” he says, noting a recent investment in a fully stabilised high-quality office property in Pasadena, California, a suburb of Los Angeles.
TripAdvisor relocated to Center 128 from an older building in the same area, says Gronning. While the project has taken time to execute – the initial purchase was made in 2011 – the result is office property with efficient access to Boston and Cambridge that commands “premium rents to other Class A product that isn’t brand new,” Gronning says. “One of the key messages in the suburban office story,” he adds, “is that tenants are willing to pay a premium to be in the best space in the best location.” For Trip Advisor, which competes for tech-savvy millennial talent, “it’s a way for them to make a statement.”