Investors flocking to safety are looking to prime office properties. But with prices rising and bidding wars erupting, are these markets already overheated? Stephanie Schwartz-Driver investigates

Investment in office markets around the world now is being fuelled by investors' demand for quality and flight from risk. There is a significant pricing gap between major markets and secondary and tertiary markets, and between higher-quality and lower-quality assets globally. There is consensus in the investment community on these two points. But the agreement stops there. There is no consensus about whether prime properties are overpriced or whether investors would be better off looking elsewhere.

"Prices for prime office properties are certainly higher," says Ray Torto, global chief economist for CB Richard Ellis. "But I do not know if they are overpriced. I do not see any fall-off in demand, so I hesitate to say they are overpriced. ‘Overpriced' suggests they will fall in price and that is not a given."

Some investment advisers are beginning to take a broader view of investment opportunities. "Our view is that for major office locations worldwide, the investment market is becoming overheated," says Milan Khatri, global property strategist at Aberdeen Asset Management. "For medium-term investors, there are better opportunities in other sectors."

According to Real Capital Analytics (RCA), pricing trends in major markets are proving to be a disincentive to some investors. Yields have been largely unchanged since the beginning of the year and cap rates remain low in the office sector in all major markets. As a result, transaction volume is shifting to other sectors as investors are tempted away from prime office properties. While global office transactions in the second quarter of 2011 were up 29% from the previous year, there were significantly greater gains in other sectors: retail was up 97%, hotel was up 80%, and even multifamily was up 38%.

In Khatri's view, cities to avoid include London, Paris and Hong Kong, and in North America, New York City and Washington DC - all prime investor targets. He stresses not only that cap rates have come down significantly in the past 12-18 months in these cities, but also that these markets tend to be very volatile. "The long-term core investor would not want to add too much risk in that sector now," he maintains.

Torto notes that the rise in investor demand for core office is a truly global phenomenon. "There is a shortage of product for investment and so much demand." But investor demand is not the same as tenant demand, and high vacancy rates globally are putting a damper on development. Torto estimates that "it will be a long time before you see building in the United States and Europe, probably not until 2014-2015."

In Europe, development activity has dropped more than 20% in expected 2011 completions, compared with 2010, according to CBRE's ‘Global Office MarketView', and in some cities, including Paris, Berlin, Brussels, and Amsterdam, a further drop in completion levels is likely. In the US, similarly, new office construction is expected to remain below historic trends until the economy improves significantly.

In Asia, on the other hand, new product coming online represents the possibility of oversupply in some markets in 2011; Beijing, Hong Kong and Taipei are the exceptions and in those cities, landlords are able to raise rents because new supply will be limited.
Torto believes that investor risk-aversion will keep a lid on prices ultimately. "There is still a lot of cautiousness among investors - this will keep prices from rising too far," he pointed out. Investors are also keeping a little more liquidity, which will temper overall demand. However, he also stresses that the office sector, and core real estate investment, remains a good bet. "Look at the spread between the yield of core real estate and 10-year treasuries. This is a pretty significant spread - real estate looks good."

Investment managers are split on what strategies are best for investors who want to commit to real estate but who are wary of overheated core markets and the bidding wars erupting over prime properties. Aberdeen is steering investors away at the moment. "Investors are caught in a tricky position. They are too late to invest in trophy properties, but they are too early to look at lower-grade properties because they are at risk from an economic recovery that may come to an end too soon," Khatri says.

Khatri believes that, rather than looking to make new acquisitions in an already overcrowded space, core investors should look at reducing the risk in their existing portfolios. Strategies include taking active management measures to reduce vacancy levels, reducing the level of gearing, or lengthening lease terms.

Looking outside major markets is not an option for Khatri. "I would be hesitant to say that investors should look at more secondary office markets, because they have not benefited from any recovery so far," he says. He does acknowledge, however, that there are opportunities in secondary markets for more active managers, even though they would be more vulnerable to any economic slowdown.

Torto agrees. "Even though there is a lot of spottiness in leasing, in general, downtown markets are doing better than suburban markets," he says. "This is because big business is doing better than smaller businesses, and big businesses prefer major downtown locations."

Some investors, however, see opportunity outside prime locations, and not necessarily in office. UK fund manager Hermes Real Estate Investment Management, which manages the property exposure of the British Telecom Pension Scheme, also sees core central business districts (CBDs) in capital cities and major city centers as expensive. "There are always pockets of value, but we do not expect to look for them in major CBDs in Europe or the United States," says CEO Chris Taylor. "It is even less likely in Hong Kong or Singapore, where there has been an even stronger growth story."

In fact, Hermes is a now seller of prime office properties in London, such as 20 Gresham Street, which the firm offloaded in March this year. Sellers of prime properties are in a strong position, says Khatri. "If you have trophy buildings, there certainly are buyers," he said.

Hermes believes that the firm will find better value for its clients by avoiding the herd. "It does not mean that we will not go into city centres," Taylor stresses, but just that the firm is benefiting from a broader focus. "We seek to anticipate the market cycle, particularly within the cyclical office markets such as City of London, and believe pricing is now looking expensive."

Hermes' partner in the US, Hampshire Real Estate, also looks to focus on market inefficiencies by avoiding the major city centres, Jimmy Hanson, president and CEO of Hampshire Companies, explains. "We have not played in New York City, even though we are based in New Jersey," he says. The focus is on the East Coast, and a deal size range of less than $50m (€34.6m) - typically too small for larger global investors but too big for smaller local investors.

Hampshire, in fact, is avoiding the office sector altogether. "I do not like office outside major cities from a leasing standpoint," Hanson says. "Outside major cities, it is a tenant-oriented market, with flat rent growth and lots of competition among landlords. People are beating each other up to offer concession packages to attract new tenants." This divide, between CBD on the one hand and suburban and regional office on the other, might moderate with improved economic conditions but will not disappear, Hanson believes. "I'm very pessimistic and I have been for a long time. Nothing has altered the landlord-tenant balance," he says.

Recent figures from CBRE back up Hanson's pessimism about leasing conditions outside major cities. Nationally, office vacancy rate in the US stood at 16.4% for the first quarter of 2011 - but compare this with the rates in New York City at 8.3% or Washington DC at 10%. Outside these prime centres, even urban markets show signs of struggle: Chicago at 14.9%, Los Angeles at 17.8%. In addition, US vacancy rates remain significantly higher than in the rest of the world. CBRE reported Asian vacancy rates at 10.3% for the first quarter of 2011, and in the EMEA region they stood at 9.2%.

Hanson sees two different dynamics outside major cities: either there is static demand in a context of oversupply; or demand may grow, but as it does new development comes on line and tenants are easily tempted to move. Northern New Jersey, in proximity to New York City, is an example of the first trend. There is a systemic surplus of office in the area, with oversupply ranging between 10% and 15% regardless of whether times are good or bad. Other areas, such as the suburbs of Dallas, are less land-constrained and new development comes on stream frequently.

As part of the Hermes joint venture, Hanson stresses that the firm is buying the same quality properties as could be found in CBDs, in terms of income stream and leasing, but they are just not in major metropolitan areas, and they are not office. "In secondary or tertiary markets, we can find a leased grocery-anchored shopping centre at a reasonable discount compared to barrier-to-entry infill locations, and we further benefit because life insurance companies like to finance that kind of investment."

Not all firms are going as far as Hermes and Hampshire, however. Globally, RCA has noted a broadening of investor interest. "We are currently in the early innings of investors expanding away from core office to achieve higher yields," says Dan Fasulo, managing director and head of research. "There has been significant recovery in values focused on apartment as well as CBD office. Investors are now looking at a situation where the spread in yields between these two and other sectors is at an all-time high."

RCA sees investors in both North America and Europe breaking out of the trophy markets - either in the search for yields or because they are frustrated with the bidding wars that develop for prime city-centre office properties. Fasulo cites the example of Blackstone, which identified that spread and, as a result, made some significant bets on retail and industrial properties, such as Centro's US shopping centre portfolio, acquired in March this year for $9.4bn. "When a well-respected investor makes big macro bets like this one, it gives other investors confidence," Fasulo says.

In Europe, RCA has seen similar trends. London and Paris may be overheated but activity has picked up in some German regional cities, such as Hamburg, as well as in Poland and Scandinavia, which show greater potential for higher risk-adjusted yields even for core office properties.

Asia is a different story, in the RCA analysis. There, most capital goes into new development and few institutional investors go in directly, preferring instead listed vehicles or funds. Although the region saw a shallower downturn, however, office is "arguably overheated," Fasulo says.

In RCA's view, spreading investment outside capital cities and major CBDs is a positive step for real estate in general. "This is going to expand the recovery that has already started," Fasulo adds. "In around six months' time, we will see recovery start to creep into secondary markets as investors start buying there."

Recovery in the office sector will vary from region to region and country to country. In the US, recovery will take longer in those markets harder hit by the housing collapse and those that experienced overbuilding. Recent research by RREEF projected that leading urban centers will recover to levels that top the last peak, but less well positioned markets will not recover until after 2015.

In Europe, the RREEF study sees a similar correlation between national economies and recovery in the office sector: markets in countries like Spain and Ireland lag the rest of the continent, but central European markets have rebounded faster than had been expected. In the Asia Pacific region, office markets across the board have already rebounded or begun their recovery.