Different Office Markets Face Similar Pressures

MBA (8/12/2008 ) Murray, Michael
Despite differences in suburban and downtown office locations, rent growth figures and supply amounts, both property markets face downward pressures ahead.

A second quarter office report from Grubb & Ellis, Chicago, expects office property prices, which fell up to 50 percent in the early 1990s and increased in the early 2000s, to decline by 10 percent to 20 percent during the next two to three years.

The report said suburban and office construction pipelines exceed 10 million square feet in the Washington, D.C. metropolitan area, while Houston, New York, Dallas-Fort Worth and Seattle have between 5 million and 10 million square feet in the pipeline. However, the amount of space under construction—as a percentage of existing inventory in downtown and suburban markets—is 2.4 percent and 2.6 percent, respectively.

"If comparing CBD versus suburban, there is not inordinately more space under construction," said Robert Bach, senior vice president and chief economist at Grubb & Ellis. "Certainly, there is more, on an absolute basis, under construction in the suburbs but the total inventory is also much larger in suburban areas."

However, Arthur Jones, economist at CB Richard Ellis/Torto Wheaton Research, Boston, said suburban markets, clearing their pipelines of smaller projects, will face a much shorter correction than downtown markets.

He said that while downtown properties trend toward Class A space, which could command higher rents and generate solid revenue for investors in a good economy, more downtown office supply can lead to difficulties luring tenants from lower-quality office space in the same market.

“This should not come as a big surprise—rents in outlying markets tend to be less cyclical because they have a much more efficient adjustment mechanism to the peaks and troughs of the economy,” Jones said. “They tend to rebound sooner from downturns and experience more moderate rent growth during boom periods. All of which bodes well for those suburban markets that are well-positioned for balanced economic growth in the future."

Robert White, president of Real Capital Analytics, New York, said high quality properties and primary markets are showing more sales, with Houston, Washington, D.C. and New York City among the best performers, as markets begin to exhibit clear differences.

“Post credit crunch, caps for suburban office property are up about 45 basis points, similar to industrial properties and strip shopping centers. Average cap rates on CBD properties are actually down slightly, reflecting a shift in sales toward higher-quality properties and primary markets,” White said.

Some industry analysts said downtown offices take longer to build, and Jones pointed out that suburbs would be in a better position to “cash in on more favorable rent growth than their downtown brethren as numerous large projects are still in the offing for key markets such as Houston, Charlotte and New York."

"Just as it takes time for these projects to be completed, it takes time for this space to be absorbed,” Jones said. “As a consequence, downtown rents will suffer steeper and more protracted rent declines during this adjustment than will suburbs whose supply and demand will be closer to a balance that should support moderate rent growth moving forward."

"Downtown buildings typically require more planning and time to execute and deliver development projects," Bach said. "Vacancy rates will rise, but the ratio between the two [suburban and office] will remain pretty similar."

Paul Jones, principal of WLJ Partners, a private equity firm based in Coral Gables, Fla., said the delivery schedule of suburban office versus downtown office is not as dramatic as it would be for some other properties.

“For industrial properties, [builders] can put something up very quickly,” Jones said. “In office, if [builders] go mid-rise in a suburban location, they are likely to have the same issues and timeframes as there may be in a downtown location, where downtown is probably streamlining the approval process.”

WLJ's Jones said locations with good mass-transit systems, including New York City, Washington, D.C., Chicago and San Francisco, would “work very well” for downtown office, as employers accommodating workers would have greater impact on suburban and downtown office.

“Commuter-type towns, such as Los Angeles, Atlanta, Dallas and Miami, [favor] suburban office as people will want to work closer to home,” Jones said. “The big lynchpin here is if gas prices continue at the levels they are at. If they do, people cannot continue to afford the commute and will want to work close to home.”

"Looking in the long term, more cities will probably build or beef up their transit systems, and that should be to the benefit of downtown areas," Bach said.