You Can't Keep A Good Investment Down!

BY TIMOTHY B. GOOD
Grubb & Ellis Company

The commercial real estate investment market is renowned for the predictability and extremes of its cycles. The most recent example is the dramatic decline and rebound in values for central business district and suburban office buildings.

Office buildings, the preferred investment of the mid-Eighties for many, are coming back with a roar after experiencing a breathtaking drop in value, demand and capital attraction.

Why does this happen? History shows that overbuilding brings down rental rates, prices and, in many cases, the entrepreneurial developer himself.

The building spree of speculative office space in the mid-to-late 1980s created far more space than the market could absorb in a timely fashion. Remember, it's all supply and demand. Turned off by the market imbalance, investors focused their attention on retail, multifamily and industrial assets for the better part of 10 years, leaving office building owners, lenders and service providers to their own devices. A semblance of balance would have to be restored before significant capital would be attracted to office properties.

The painful healing process included:

• Virtually giving away prime space at rental rates that did not support the capital structure of the office building investment, much less provide a return on investment

• Loss of liquidity

• Lack of take-out/permanent financing

• Values reduced to as little as 50 percent of replacement costs

• Many speculative buildings constructed during the late part of the last decade being turned back to lenders or financial partners by their overwhelmed developers.

The process resulted in financial institutions assuming control of a whole generation of buildings. Many institutions then were faced with the unpleasant prospect of selling these assets into a market that had chased investors away, exacerbating the decline in values. There seemed to be no bottom. Planned new construction halted. It was time for the long journey back to the beginning.

It took more than five years, but vacancy rates and speculative construction reached historic lows, while demand for space by growing companies in our booming economy increased. This created a push on rental rates resulting in rent spikes in the Seattle and Bellevue central business districts and the suburban markets alike.

Probably the only surprising element is the rate at which demand, rents and values have accelerated.

The first signs of a rebound surfaced in late 1995, with the sale of Key Tower to the City of Seattle at $100 per square foot, a price many thought to be excessive. Since then there have been several trades at increasing prices per square foot, and at lower capitalization rates.

For example in 1996 there were 15 sales of major office properties in Puget Sound: in 1993 there were only two. Thus far in 1997, there have been seven -- and there will be many more. Prices per square foot are approaching replacement costs for suburban buildings, with Bellevue's high quality Quadrant Plaza trading at $178 per square foot.

Seattle's CBD is headed in that direction, but still has some distance to go. The sale of the Marsh McLennan Building at $132 per square foot, and 520 Pike at $150 demonstrate the steep increase seen in the short period since the Key Tower transaction.

The Southend office market, traditionally slower to respond, is not being left behind either. Recent acquisitions by astute investors including RREEF, Lowe Enterprises and Martin Smith illustrate the underlying strength and promise of that market. There has been nothing slow and graceful about the pace of the market, and it has caught many owners, lenders, developers and tenants off-guard.

Due to the lack of new construction, tenants, particularly those in excess of 10,000 square feet, have but a handful of choices for existing space. Spaces that are available today are typically offered at rental rates 30 to 50 percent higher than rents the tenants are currently paying. Higher rents are driving the value of office buildings up, and are attracting investors back to them.

Once again the most valuable of all commercial real estate products makes economic sense. Investors see a substantial investment upside as leases expire and tenants renew at higher rents. The investor has expectations of increased cash flow through the higher rents, appreciation by virtue of increased user and investor demand, and protection in value as they are making acquisitions at below replacement costs for similar new competitive product.

Will it happen again? Will we once more have unbalanced market conditions? Maybe. But this time around, at least so far, there are some self-imposed industry governors on what gets built, how and why. Lenders and equity capital sources are still gun-shy and are imposing conditions on developers, such as stiff pre-leasing requirements and realistic effective rental rates.

These restrictions will restrain the naturally optimistic developers. This time around, there is a good chance new office space will be constructed only to meet real demand.

Timothy B. Good is a vice president with Grubb & Ellis Company.