Despite the overall consensus that commercial real estate is in the late stages of its current cycle, investors in the office sector continue to see strength in the sector. Expectations for rents and occupancies remain bullish. And while there is a general sense that cap rates will rise, respondents overall remain optimistic about the prospects for the space.
Those were among the findings in NREI’s fourth annual research survey aimed at gauging sentiment about the office sector for the coming year.
Respondents were asked to rank the relative strength of their region on a scale of 1 to 10. The West (8.2) led the way, followed by the South (7.9), the East (7.4) and the Midwest (6.8). The scores for the East, Midwest and South all rose from 2017, while the score for the West remained flat. The West has been the top market in each of the four surveys NREI has completed on the office sector.
The state of investment
Respondents were asked to estimate cap rates in their regions and nationally and generated figures of 6.2 percent and 6.3 percent, respectively. Those numbers are a bit lower than market statistics indicate. For the fourth quarter of 2017, Real Capital Analytics (RCA) reported an overall office cap rate figure of 6.7 percent based on total volume of $37.8 billion in deals.
For each of the four years NREI has conducted this survey, a majority of respondents has answered that they’ve expected cap rates to rise in the next 12 months. In fact, office cap rates did rise some in the past year. After hitting a low of 6.4 percent in the third quarter of 2016, office cap rates have hovered in the 6.6 percent to 6.7 percent range since, according to RCA’s figures.
In the latest survey, 14 percent of respondents said they expect cap rates in their region to decrease in the next 12 months, while 73 percent expect them to increase. (The latter figure is up from 67 percent in 2017 and 54 percent in 2016.) Another 13 percent of respondents in the 2018 survey said they expect no change.
The numbers are similar at the national level, where 75 percent expect cap rates to increase (up from 73 percent in 2017), while 14 percent expect them to decrease (unchanged from a year ago) and 10 percent expect no change.
In terms of respondents’ own plans, the numbers in this year’s survey matched last year’s exactly. A little more than half of respondents (57 percent) again said they expect to “hold” properties in the sector in the next 12 months. About one-fifth expect to sell (21 percent) and a similar number is looking to buy (22 percent). Those numbers have been consistent in each of the last three surveys.
On the capital availability front, responses were similar on both the debt and equity markets. In both cases, respondents noted that capital markets have stabilized. About 50 percent of respondents said capital availability was unchanged for both categories (49.3 percent for equity and 51.3 percent for debt), while about less than one-fifth said capital was more widely available (18.5 percent for equity, 17.9 percent for debt).
Respondents were also asked how they see various financing aspects changing in the next 12 months. For the second consecutive year, an overwhelming majority expect interest rates to rise (87.8 percent this year vs. 91.1 percent in 2017).
When it comes to the risk premium, the spread between the risk-free 10-year Treasury and cap rates, respondents were split, with 43.7 percent expecting an increase while 42.7 percent expect it to remain the same.
Two factors that a majority of respondents do not expect to see much movement on are loan-to-value (LTV) ratios and debt service coverage ratios (DSCR). More than three-fifths (65.9 percent on LTV rates and 68.1 percent on DSCR) expect those to remain flat. In total, 46.5 percent of respondents to this year’s survey expect loan terms to tighten. That’s virtually unchanged from 46.1 percent who answered that way in 2017. In addition, 39.9 percent in this year’s survey said loan terms would remain unchanged, while only 13.6 percent expect them to loosen.
Respondents were also asked about the outlook for central business district (CBD) office properties in comparison to suburban complexes. Responses were similar for both property types and also mirrored overall sentiment for the sector. In both cases, about two-thirds of respondents expect cap rates to increase (71 percent for CBD, 76 percent for suburban), while less than one-fifth expect cap rates to decrease (16 percent for CBD and 14 percent suburban). In both cases, the percentages of respondents expecting cap rate increases was up slightly from 2017.
Suburban outpacing CBD?
Respondents ranked CBD buildings and suburban properties as equally attractive (exactly 50.0 percent for each). But when it came to projecting which type of investment offers higher long-term yields, suburban (53.0 percent) slightly edged out CBD office buildings (47.0 percent). In 2016, sentiment favored CBD properties and in 2017 it was almost evenly split (50.8 percent for CBD properties and 49.2 percent for suburban properties).
Indeed, investment sales volume for office assets in the suburbs is now outpacing sales in CBDs, according to David Bitner, vice president in charge of capital markets research with real estate services firm Cushman & Wakefield. He notes that in 2017, investment sales volume in CBDs dropped 23 percent from the previous year, while suburban sales volume rose by 2 percent.
The New York metro led the drop in urban sales volume with a 37 percent decline, which Bitner attributes to fewer assets on the market and high pricing. He notes that some buildings had already traded two or three times during the current cycle, and an abundance of liquidity in the market allowed trophy asset owners to refinance rather than sell.
In addition, many institutional investors became wary about asset pricing due to the willingness of aggressive investors, including foreign players, to pay top dollar, making it hard to compete on bids.
“Investment activity continues in the suburban office market, and yields are liable to be as good or better than CBD markets,” Bitner notes. “People tend to forget that 70 percent of office inventory nationally is in the suburbs, because more people live and work in the suburbs than in urban centers.”
Expanding job growth is creating office demand in suburban submarkets that have never recovered from the recession. Suburban markets in the District of Columbia metropolitan area, for example, are showing signs of a comeback, according to Gerry Trainor, executive vice president for D.C. capital markets with real estate services firm Transwestern. He notes that an upswing in performance of two Northern Virginia submarkets, where rent growth is 15 percent, may signal a comeback regionally.
The development pipeline
A majority of respondents said the level of development is about right for the sector, with only some fearing that too much space is being built. In this year’s survey, 59.7 percent said the level of development is the right amount. An additional 11.5 percent said there is too little development occurring. Overall, 18.5 percent said there is too much development taking place, but that figure is down from 21.7 percent a year ago.
When asked to estimate how much additional supply their market could absorb, 29.8 percent said their market could absorb less than 5 percent of current inventory. Another 28.9 percent answered “5 percent to 9 percent” and 20.6 percent said “10 percent to 14 percent.”
Speculative office construction—as a percentage of supply underway—is expected to be at the highest level it has been in years in 2018, according to commercial real estate data firm CoStar.
Still, some experts say there is enough demand out there for new, quality space—even as the national vacancy rate has not seen a significant drop since 2010, and there is an uptick in expected deliveries this year.
As a percentage of rentable area under construction, speculative office development this year is at 40 percent, totaling 49 million sq. ft. of supply underway. That’s the highest percentage CoStar has seen over 13 years, and it is 200 basis points higher than the previous yearly high recorded in 2007, which saw 69 million sq. ft. of speculative development. The figure has gradually trended upward in recent years—2017 saw 50 million sq. ft. of speculative construction, roughly 37 percent of the total—as after the recession most of the new office product was built-to-suit.
Peter Muoio, chief economist at Ten-X, says he is not as concerned about too much speculative supply as he is about the overall supply in the markets that recovered well after the recession—typically, gateway cities including New York and San Francisco that have been seeing growing economies, an influx of capital and strong office job growth.
Outlook for occupancies edged up slightly from previous surveys. The majority of respondents (69 percent) said they expect occupancy rates to rise in their region in the next 12 months. That’s up from 65 percent in 2017 and 2016. However, about one-fifth, or 18 percent, said they think occupancy rates will decline (vs. 23 percent in 2017). And about 13 percent said they will remain flat.
The picture was similar on rents. Sentiment became slightly more bullish than it was in 2017. Overall, nearly four-fifths of respondents (78 percent) expect rents to rise in the next 12 months, while only 13 percent expect them to decrease. That figure is up from 73 percent in 2017 and 77 percent in 2016. In 2015, 83 percent said they expected rents to rise and only nine percent said they expected them to fall.