Investors Turn Attention to Suburban Office

Due to price escalations and limited supply of CBD office assets, investors are reconsidering the suburbs in their quest for yield, notes Leah Gallagher, Transwestern's San Antonio city leader.

Gallagher, LeahStabilized suburban office fell out of favor with investors during the latest economic recovery, but that may be changing as the quest for yield drives buyers away from highly competitive bidding in central business districts.

Following the Great Recession, most institutional and foreign investors restricted their acquisition criteria to stabilized, well-located CBD properties, creating competitive bidding that drove up pricing and compressed returns. As asset values recovered, the number of value-add buyers—chiefly private equity investors—grew to become a dominant force in acquisitions as well.

Due to price escalation, investors now face difficulty achieving targeted returns on new core acquisitions. Nationwide, CBD office assets traded at an average capitalization rate of 5.6 percent in the first quarter, compared with suburban office’s 7 percent cap rate, according to Real Capital Analytics. But with fewer buyers in outlying submarkets, there has been less downward pressure on cap rates, particularly for stabilized office.

Anecdotal evidence suggests office investors are reconsidering the suburbs. While institutions and major funds are largely locked into preset acquisition standards and minimum initial returns, more nimble private equity investors confide that they are adjusting their criteria. Unable to find suitable subjects for value-add plays, these buyers are increasingly willing to look at best-in-class, stabilized suburban offices.

There are good reasons to cast a wider net. In many U.S. markets, there are a limited number of Class A office buildings in dense, walkable urban neighborhoods. And in markets such as Austin and San Antonio, which have been experiencing strong job creation and rapid growth for years, value-add scenarios are scarce.

Yet some suburban markets contain an oversupply of high-performing suburban assets, many of which offer returns similar to those available on value-add properties.

In North Houston, for example, a vacant office building marketed recently as a value-add opportunity drew more than 50 inquiries and 10 purchase offers. The buyer will need to lease the space, including any renovations and tenant finish-out necessary to complete a value-add strategy.

In the same submarket, a well-located, multi-tenant suburban office building has failed to attract a buyer after nearly two years on the market, despite being 90 percent occupied. A majority of its leases will reach maturity within five years, giving a buyer the opportunity to increase rents. If the stabilized property sells this year, then it is expected to garner roughly the same price as the vacant, value-add opportunity nearby. Obviously, the vacant property will require a greater investment to reach its potential, so the stabilized asset offers a healthier return.

Playing to value-add buyers, some brokers are marketing stabilized suburban offices as value-add, highlighting the delta between in-place rents and the market. An investor that is nimble enough to begin considering stabilized suburban properties, however, will have a wealth of attractive buying opportunities to consider.