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Strong Office Sector Fundamentals Sustain Value-Add Investment Strategies

With moderate new construction and steady job growth, investors are willing to tolerate the risk of value-add strategies.

While the office market remains strong, conventional wisdom dictates that the later in the cycle, the more risky the investment in value-add office assets becomes. But investors are bucking preconceived notions about risk in a mature cycle, as there are currently few signs of declining office occupancy.

“This is a different office market than what we've seen in the past; there's still strong growth, so investors aren't shying away from opportunities, but they're judicious about the timing,” says Andrew Warren, Des Moines, Iowa-based director of real estate research with professional services firm PwC. Investors are looking for projects that can be turned around over the next two years, he notes. But the turnaround can be further out if the location allows them to catch upside in the next recovery.

Lack of over-building in the sector has also made it easier to make value-add investments this late into the cycle, Warren adds. “Any new space coming on-line is snapped up immediately, so there's not a lot of empty spec space sitting around.”

Most value-add investors are looking at specific markets where they see growth or where growth is expected in the next cycle, as well as core markets with a shortage of office space, he notes. This includes assets on the fringe in core markets like Seattle, and growing secondary markets in Texas, Tennessee and Florida, where a diversity of economic drivers are creating investment opportunities.

Investors are also are interested in markets impacted by shifting demographics as a result of migration from Northern and Midwestern cities to Southern and Southwestern U.S., Warren notes. Many employers are looking to relocate or open offices in cities with lower wage and tax environments and a lower cost of living that can attract young educated talent.

“Obviously this includes growing tech hubs, but also support services required by growing populations, like finance, accounting, advisory, and personal services.”

While suburban assets tend to carry higher risk than urban assets, investors are finding opportunities in growing suburbs with mass transit access to urban cores and in mixed-use development, Warren says.

In a normal cycle, investment in urban value-add office properties generates yields of about 15 percent, but depending on the market, investors can expect about a return of about 12 percent overall on projects now coming to market due to compressed cap rates, according to Warren.

In certain markets—for example, the D.C. metro area, yield can be higher, according to Gerry Trainor, executive vice president for capital markets in the Washington, D.C. office of real estate services firm Transwestern. Yields vary between 14 and 20 percent in local markets, depending on the amount of added value needed and location, he notes.

Office investors in the D.C. metro are more attracted to value-add assets than new office construction, Trainor says. Ideal assets for acquisition are 50 percent to 80 percent leased with opportunity to create value through building updates (i.e. lobby and restroom renovations) or adding amenities like gyms and conference centers.

The D.C. area has a total of about 430 million sq. ft. of existing office space, with overall vacancy at 12.0 percent, according to Transwestern data. Another 12 million sq. ft. of new office space is under construction, with 60 percent of it already pre-leased.

“Amazon's HQ2 is driving a lot of speculative office development in Northern Virginia, but not so much in Maryland or the District,” Warren says.

With no change in economic fundamentals and continued low interest rates, value-add office investment activity will continue to be strong. Trainor notes. However, if the trade war with China continues, economists project a 30to 40 percent chance of recession in the near future, which would impact current investment strategies.

The office sector may be positioned for mild recession, adds Warren, but “if anything happens in the near term, it will be an adjustment to a new normal.”

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