Small Is Beautiful
- Jul 18, 2012
The long-awaited increase in secondary market transactions is starting to happen. Through the first half of 2012, CoStar says that office sales in markets outside the top six (New York, Washington, D.C., San Francisco, Boston, Chicago and Los Angeles) accounted for 45 percent of total activity, up from 36 percent in 2012 and identical with the 2003-2007 average – the boom years of the last expansion cycle. Among the high-profile office transactions closed this year in smaller markets are the Hearst Tower and Fifth Third Center in Charlotte, which went for $245 and $175 million, respectively, to a REIT and an equity fund; Huntington Center in Columbus, sold to a large private investor for $177 million; and Chase Tower in Indianapolis, picked up by a REIT for $201 million.
Some of this is related to the slow but broad improvement in leasing market conditions, with secondary office markets attracting 77 percent of total net absorption in the second quarter and 98 percent in the first quarter, according to CoStar. But mostly this is due to “yield fatigue”: Cap rates have tightened so much in supply-constrained coastal markets, particularly CBDs, that buyers are taking a pass and chasing higher yields in secondary markets.
Larger transactions priced at $20 million and higher command lower cap rates than transactions below that threshold: 6 percent versus 7.5 percent in the second quarter. But both trend lines have been coming down in recent quarters, indicating that investors are warming to lower-priced assets – some combination of Class B or value-add deals, smaller-size properties and assets in secondary markets. This is ironic in that commercial real estate investors appear willing to assume more risk at a time when global investors—spooked by the euro zone financial crisis, the fiscal cliff in the United States and slowing economies across the globe—are fleeing to low-risk assets like U.S. Treasuries, where the yield on the 10-year note is hovering around 1.5 percent, near record lows. Low interest rates translate into greater availability and more attractive terms for mortgage loans, which has been one reason behind the growing volume of transactions this year – up 21 percent year-to-date through May for all commercial property types.
Economic conditions have worsened for a third consecutive summer, putting the United States perilously close to a recession. This would tend to re-focus investors on the best assets in primary markets and dampen interest in secondary markets. But as long as the economy continues to defy the prodigious headwinds, secondary markets will gain traction with investors.