1996 A Remarkable Year For Eastside Office Properties

1996 A Remarkable Year For Eastside Office Properties

BY QUENTIN KUHRAU
Unico Properties

The period between 1995 and year-end 1996 produced one of the most dramatic increases in building values that the Eastside has seen. Driven by increasing rents, decreasing tenant improvement costs, commissions and low vacancy rates, property values all over Puget Sound are on the rebound.

What are the market dynamics that fueled such a remarkable year?

Increasing rents.

The increasing rent environment is well known to most as it has been both predicted and now witnessed. But these higher rents tell only part of the story. Very few, if any, real estate experts predicted the extent to which rents have risen. Institutional buyers and sellers have been arguing whether a four to eight percent short term annual improvement in rents is achievable. Rent increases in some Puget Sound markets are twice the upper end of that range.

Visible improvements in true cash flow.

The remainder of the story is the extent to which the "cost" of securing a lease has dropped. A building's true cash flow is driven by three components: revenue, expenses and capital costs. Capital costs have fallen more dramatically than rents have risen. With revenues poised to increase, expenses growing modestly and capital costs falling, the prototypical office building's true cash flow is positioned for dramatic improvements in a short period of time.

Heightened investor interest.

Local, national and international investors are already attracted to the Puget Sound because of its strong economy, physical barriers to new supply and lifestyle appeal. However, given the improving market dynamics, they are even more primed for investment in this area.

Why was 1996 such a strong market for Eastside building sales?

Simply, the hard evidence of an improving market finally arrived. From 1995 to 1996, Eastside office property buyers were somewhat hesitant to pay higher prices based on forecasted rent growth, without hard evidence. Until mid-1996, the so-called "hard evidence" consisted of crystal ball predictions of real estate observers who forecasted higher rents and lower capital costs. But that changed throughout the latter half of 1996 as forecasts evolved into reality.

By comparing building transactions in 1995 with those in 1996, there are three trends which explain the rise in building values.

The most significant trend is the variance between the average going-in cap rates between 1995 and 1996. During this period, the average going-in cap rate decreased more than 200 basis points, a remarkable decline in just one year. Furthermore, the price per square foot almost doubled.

Some of the cap rate decrease and per square foot price increase, is attributable to a better quality product being offered for sale. But clearly a sizable portion of the value improvement is attributable to buyers' perceptions of an improving market.

Second, the buildings were generally older, and as would be expected, not as high quality as the 1996/97 buildings that traded. Lastly, the average transaction size was smaller in 1996/97. Since older properties have a lower cost basis, these situations allow the seller to book a gain in the earlier part of a real estate recovery than the seller of a newer, more institutional property.

Also, all 1995 property buyers were either local, experienced veterans or entrepreneurial, out-of-town buyers with good access and understanding of local market dynamics. These buyers were able to recognize the upward trends occurring in the market and committed their capital more quickly than the institutional buyers that entered the market in 1996.

Kenyon Center

To illustrate these trends, consider Unico Properties' recent experience in the sale of Kenyon Center. Kenyon Center is a 91,500-square-foot, steel-framed, glass-curtain-wall building located adjacent to I-90. It was fully occupied by a tenant which had less than four years remaining on its lease.

The project was valued in mid-1995 for the owner who was considering a sale. Based on the 1995 investment market, and the cost of possibly having to re-tenant an empty building, the project was valued at $115 per square foot. The price totaled $10.5 million with a 10.7 percent cap rate, well within the context of the 1995 average cap rates which were running at 11.4 percent, albeit for lower quality projects.

Unico took the building to market in mid-1996, with an asking price of $136 per square foot or $12.5 million, and an asking price cap rate of 9 percent. Unico closed the sale in October 1996 to a REIT at $133 per square foot or $12.155 million. By waiting for the market to mature, the seller was able to increase the value of the sale by nearly 15 percent, or $1.7 million.

Will Eastside building values continue to rise?

It is hard to conceive that building prices will see as much of a dramatic improvement in value in 1997 and 1998 as was observed between 1995 and early 1997. However, no one truly predicted (out loud anyway) the rapid increase seen between 1995 and 1996.

One road block to prices escalating too high is an institutional buyer's perception of replacement cost. An institution will have a hard time convincing its investment committee that an existing building should be purchased above depreciated replacement cost.

Determining replacement cost in the "burbs" is a difficult concept because few investors know how to accurately value the land component. Investors have traditionally viewed high teens to low $20s per buildable square foot as a reasonable suburban land value.

However, recent trades of raw land question these assumptions as sales are occurring in the mid-$50 range per buildable square foot. If these trades are extrapolated into replacement cost analysis, then there is some room for prices to rise.

One relatively risk-free prediction is that the number of transactions in 1997 will increase. There is pent up demand and pent up supply.

Pent up demand is driven by institutions with significant capital to spend on Seattle real estate and not enough product to spend it on. This is further fueled by institutional lenders which have the same problem and will help leveraged buyers pay higher prices.

Pent up supply has been created as owners, or their deed-in-lieu lenders, have held on to their real estate through the tremendous devaluation that occurred in the early 1990's waiting for today's market to arrive.

Quentin Kuhrau is vice president of Investment Advisory Services at Unico Properties. Unico recently added the investment advisory group to complement its property management, ownership and construction services.

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