Why Fundraisers Like the Value-Add Urban Office Sector

JLL Capital Markets Managing Director Nooshin Felsenthal analyzes the trends that are motivating more investors to target these opportunities this late in the business cycle.
Nooshin Felsenthal

When many consider investment into the office sector, they think of the core assets that define skylines and can serve as marquee assets in a portfolio. It’s true, the flight to quality has undergirded much of the liquidity we have seen in the office sector over the last several years. 

However, with the U.S. economy in the second-longest expansion cycle on record, some investors are focusing less on those core assets—the one’s that would likely hold their values the best in the case of an economic slowdown. Instead, they are choosing to focus on value-add urban office assets. This is the sector where liquidity is highest.

While it may seem counter-intuitive to buildings that might be riskier, there are several factors driving these value-add investment strategies.

A concentrated hunt for yield and willingness to look outside of primary markets are factors contributing to a rise in investor interest in the value-add office space. And fundraising continues to favor higher-returning strategies.

The search for yield

Over the past 12 months, rents have risen by 2.8 percent, which is consistent with annual gains in recent quarters. But for Class A space, year-over-year growth has been slower at 1.7 percent. Holding back Class A rent growth is the inflection point being approached in Central Business Districts (CBDs), where new supply is delivering and second-generation blocks are hitting the market.

At the same time, core cap rates continue to remain in the four- to five-percent-range in many primary gateway CBD markets for these assets. These barriers have made many investors look outside of core product to value-add urban offices.

While initial yields on value-add office investments may be thinner than core product, as they require some effort and capital to achieve stabilization, we often see value-add office yield on cost build to at least a 150- to 200-point premium on core product.

Value-add investors are also looking to take advantage of current pricing and are cautious about the potential for the market to soften. This is leading some investors to compress their hold horizon. Where it was once standard to build value and sell on a five-year plan, three years is increasingly becoming the new norm.

Fundraising focusing on value-add

As a reflection of this strategy’s popularity, we have seen fundraising for value-add strategies increase notably. Value-add funds continue to be very active in the markets, accounting for 70 percent of fundraising through the third quarter. These funds are also getting more focused, as opposed to being more diversified in recent years.

This is pushing dry powder to historically high levels, totaling $180 billion through the third quarter. The amount of dry powder does highlight the challenges managers are facing to deploy capital. This continues to drive the imbalance between capital supply and demand in the real estate capital markets.

Rising tide lifts all markets

The search for those opportunities has more frequently pointed investors toward secondary markets supported by strong fundamentals. Strength in secondary markets continues to be a significant driver of investment activity. In the first half of 2018, the top three markets in terms of year-over-year growth in office transactions were Minneapolis, Raleigh-Durham and Nashville.

These markets have excellent labor pools and fast-growing populations, making them a prime target for investors looking to gain a foothold there.

Moving forward, there is no sign of a softening in demand for value-add office buildings. As pricing for core product remains elevated and yields remain steady, the value-add strategy will continue to attract capital.