Bridging the Office Market’s Buyer-Seller Gap

By Michael Dewey, Senior Vice President of Investments, PMRG: A growing number of investors with office buildings on the market are becoming uneasy this summer.
Michael Dewey

Throughout the Sun Belt and extending up the Lower East Coast and California, a growing number of investors with office buildings on the market are becoming uneasy this summer. On the heels of the busiest transaction year since the Great Recession, deals are fewer and further between.

The same discomfort is spreading among buyers seeking value-add office projects to acquire and improve through repositioning strategies. Inspired to continue acquisition programs that penciled out well in recent years, value-add investors now find themselves out of step with seller expectations. The price tags on many properties have increased to levels that seem to wring the profitability from buyers’ repositioning scenarios.

What triggered the stall-out in transaction activity? And what can lead buyers and sellers to the kind of price agreement necessary to close deals?

The Great Divide

In a nutshell, the slowdown in deals reflects heightened concern in the market over prospects for continued economic growth. That’s not surprising in a presidential election year, and is especially understandable in light of recent global events, including Great Britain’s vote to exit the European Union. Time will tell whether the U.S. economy is flattening or merely pausing before another round of slow growth.

This feeling of uncertainty manifests in the office investment market as reduced availability of credit, a smaller pool of buyers, and a widening gap between buyers and sellers on appropriate pricing.

Reduced access to credit is already evident in a scarcity of new CMBS loans and increasingly stringent requirements imposed on borrowers. Banks typically offered 70 percent loan-to-cost financing for office acquisitions in 2014 and 2015, but are more likely to draw the line at 60 or 65 percent financing today.

Tight credit contributes to the second factor holding back transaction volume, which is the thinning ranks of potential buyers. Highly leveraged buyers or those that depended on CMBS financing are now out of the running for deals coming to market. The investors still seeking office properties today include a higher concentration of patient capital or the type of buyers that will pass on a deal priced beyond their comfort level.

That brings us to the third and, perhaps, greatest challenge to buying or selling office properties today: the price gap. For non-trophy office buildings in the major southern and coastal markets, seller price expectations typically exceed the amount that buyers are willing to pay by as much as 15 percent.

That percentage is a vestige of pricing models that worked well in recent years, when buyers and sellers could agree on prices reflecting current asset value, plus expected rent growth. Today, however, Wall Street is questioning whether office rent growth can maintain its trajectory.

In order to justify the 15 percent premium over current value that many sellers seek, a buyer would have to increase rents by 15 to 20 percent within the first few years after acquiring an asset. Considering that lease rates have already appreciated by roughly 30 percent during the current market cycle, it is unlikely that rents will grow another 20 percent before the cycle peaks.

Finding the Middle Ground

There is plenty to celebrate in the office market. Fundamentals remain healthy, with tenants absorbing more and more of the available space in Dallas, Atlanta and other markets (Houston’s oil woes making it an exception to the rule). Nor is the market wrestling with a frenzy-fueled pricing bubble, or a crisis of underwater borrowers unable to replace loans approaching maturity.

Investors can find profitable acquisition opportunities by casting a wide net and evaluating each property for its unique value-add potential. Sellers can still find investors willing to pay a premium over current value for well-located assets with genuine potential to outperform competing properties in the same submarket.

The key to closing deals in the months ahead will be attention to property details rather than on cursory searches for buildings that fit a general profile. The best-performing properties in a submarket do indeed merit a premium price, but evaluating that market standing requires submarket analyses. In other words, smart investors will study all the office buildings competing in the submarket, not just the subject property, before an acquisition.

Perhaps moving past the November election will unfetter the economy for continued growth, boosting investor confidence and office rents along the way. Regardless, buyers and sellers must agree on a price to close a deal. The safest path to that middle ground is for each party to take a realistic view of the specific asset’s current value and prospects for rent growth.

Michael Dewey can be reached at