The office sector continues to face a litany of challenges with elevated occupancies, obsolete buildings and constrained liquidity from debt markets. On the other side of the coin is a rare opportunity to acquire high-quality assets at steeply discounted prices.
“A lot of investors today have drawn a big X across office as a product type for investment. We’re not afraid of office. And, in many ways, we look at office as perhaps being one of the best investment opportunities in terms of the product profiles,” says Joe Gorin, head of U.S. and European real estate investing at Barings.
Fundamental real estate investors focus on investing at discounts to replacement cost and higher spreads relative to risk-free rates. From that perspective, there’s an argument to say there’s no better opportunity today than in acquiring office assets. However, office also is one of the most complicated product types because it has become a highly differentiated sector, from top-performing best-in-class assets to empty buildings and a broad mix in between.
Capital has been sitting on the sidelines, waiting to see how office dislocation is going to play out with the added stress from the higher interest-rate environment forcing a bigger reset in values. “What we’re seeing right now is a return of investor appetite to evaluate and potentially pursue office investments in select cases,” says Daniel Younger, senior vice president, capital markets, at Lincoln Property Co., a global full-service real estate firm.
Lincoln is in the market acquiring assets across a few different strategies. “We have a pretty deep base of investors we’ve been talking to who are coming back to the table with us and recognize that the opportunity to originate new office investments in this dislocated market environment could prove to be one of the best new investment cycles for office buildings in many generations,” says Younger. The firm also is starting to see more buyer competition, particularly for trophy buildings.
Bifurcated market
The office sector appears to be near or at the bottom of the cycle, and the return-to-office movement is gaining traction. However, there is a clear bifurcation as employers gravitate to well-located prime class A office space to attract and retain the best talent. KBS is one office owner that saw an acceleration of leasing across its class A office portfolio ahead of the Fed’s recent rate cut, and the firm expects the trend to continue.
“We see a bifurcation not only in office product type but also within individual metro areas,” adds Robert Durand, executive vice president, finance at KBS. For example, the Century City submarket in Los Angeles is experiencing demand and occupancy growth due to the amenities offered within the submarket and its Westside location. In fact, there is new office construction happening in Century City, while only a few miles away in downtown Los Angeles office vacancies continue to rise, he says.
Data now emerging that validate the outperformance of newer, well- located assets are fueling investor interest in best-in-class assets.
According to JLL, newer-vintage buildings built in 2015 or later have significantly outperformed older buildings in their ability to both attract tenants and command premium rents. Between second quarter
2020 and second quarter 2024, newer-vintage buildings generated roughly 137.6 million square feet in positive net absorption, compared with 48 million square feet of negative net absorption for older buildings. Rents for newer-vintage assets average $60.55 per foot, compared with $37.95 per foot for assets built prior to 2015, according to JLL.
The value proposition is attractive given the fact that asset prices are now deeply discounted compared to a few years ago. “If you have the courage to underwrite those assets continuing to perform well, you have some great opportunities to invest in that category of office asset,” says Gorin. There also is a value-add opportunity to reposition well-located buildings that may need renovations or new amenities to create high-demand assets, he adds.
On the other end of the spectrum, finding solutions for obsolete and less functional commodity office remains an ongoing problem. Likely, those redevelopment opportunities are going to come down to the location and underlying land value. Office could follow a similar path to retail, where there has been very little new shopping center construction over the past decade, and now the assets that survived are doing very well in terms of reconfiguring their merchandising mix and attracting the best tenants.
Those retail owners are now seeing strong occupancies and positive NOI, but it took a decade of no supply for that to happen, notes Julie Ingersoll, CIO Americas direct real estate strategies for CBRE Investment Management. “Similar to retail, we need to see a lot of stock taken offline. We need to see a lot of teardowns, both in city centers and in the suburban office asset class,” she says. For example, CBRE IM has been looking at suburban office where there is an opportunity to repurpose that land for industrial assets. That is easier said than done because it is difficult to find those development
opportunities that will underwrite, and many municipalities aren’t looking for extra industrial in their backyard, adds Ingersoll.
Varied investor appetite
Making an investment case for office remains a tough proposition for investors. Many institutions were already making moves to reduce allocations to office and diversify portfolios to include more alternative sectors even before the pandemic.
Some would argue that an institution’s current allocation to office is influencing the way they’re now thinking about office investments. “Investors who entered into the pandemic with a lower allocation to office have a different view of office appetite than investors who went into the pandemic with large allocations,” says Ingersoll. Those with lower allocations are more open to opportunistic investing, whereas those with larger allocations are dealing with challenges and don’t want to add to that office exposure risk, she adds.
Those that are interested in acquiring office are playing the long game, with the likelihood that there could be anywhere from two to 10 years of pain ahead for the office sector as it works through the surplus of space and obsolescence. Although there are some signs of a recovery in office with a shift to positive net absorption in second quarter 2024, the overall national vacancy rate edged higher to 19.1 percent due to new construction, according to CBRE.
“The way we look at the office sector is similar to how we have previously looked at the retail sector, which is that it may take a decade for us to get out of this cycle. So how can you underwrite an exit in year seven as a result?” says Ingersoll. “I think the right capital for modern, best-of-the-best office today is very long institutional capital that doesn’t have to exit in five, seven or 10 years. And the problem with most of that generational capital is they have too much
office already. So, there isn’t a big pocket of capital looking at office today.”
Nuanced strategies emerge
Lincoln is pursuing a few different strategies as it relates to office. The firm has an appetite to acquire best-in-class, well-located, highly amenitized assets similar to what it’s been actively building for a number of years. On the other end of the spectrum, Lincoln also is pursuing a couple of opportunistic strategies.
One is acquiring functionally obsolete product where there is an opportunity to raze the existing structure and redevelop as a new use, such as workforce housing, hospitality, industrial or potentially even new office. “We’re seeing a lot of that in high-barrier-to-entry markets like Southern California or on the East Coast,” says Younger. For example, Lincoln is currently redeveloping an older-vintage, low-rise office building in Orange County into a new industrial project.
Two, the firm is acquiring existing office buildings that can be repositioned with investment in renovations and amenities. In those cases, the company is heavily focused on the cash flow profile of a building. The investment team has a big focus on being able to deliver some contractual cash flow returns with existing tenancy and then driving toward more of an opportunistic return by holding, and hopefully restabilizing, an asset over a five- or seven-year period.
“We also recognize that when we’re making those types of office investments, the road ahead is not going to be totally straight, and it’s not going to be an immediate overnight return to the office environment that we were familiar with several years ago,” says Younger. “So, in most cases, we’re underwriting with capital reserves and an ability to weather the storm as office space and the workplace recover.”
Buying opportunities
A key component to executing on office strategies in the current market is being able to acquire properties in good locations at the right basis, which in most cases means a healthy discount to replacement cost. For example, Barings acquired an office asset in the Route 128 corridor in Boston in an off-market transaction for more than a 50 percent discount on what the previous owner had in the asset, and at an approximate 50 percent to 60 percent discount to replacement cost. “Even for a core asset, we’re not willing to price it as core. So even if we’re buying higher income yield, we’re going to want value-added returns for investing in office,” says Gorin.
Given the multitude of risks, investors are being cautious in how they’re underwriting deals. Barings is underwriting with higher-than- average cap rate spreads to the risk-free rate in terms of its income yields. The team also is taking a conservative approach to the exit and not assuming that cap rates are going back to the 4 percent or 5 percent exits that existed in the past.
The key question that investors are asking in today’s market: Is this the type of building that is going to draw people out of their home to go to work? In a market of haves and have-nots, those buildings that are in demand are typically the ones that are highly amenitized with good access to transportation and workers, as well as those buildings with character or that offer something unique or interesting. “We need to provide an experience, and when you can do that in the right locations, there’s real pricing outperformance,” says Gorin.
Maturities fuel buying opportunities
Loan maturities represent a huge pipeline for prospective deals. According to S&P Global, $368.4 billion in office loans is set to mature between 2024 and 2028 based on the value of the loans at origination.
Although lenders have been working with borrowers to grant short- term extensions, situations where owners are unable — or unwilling — to support their assets with additional equity is resulting in borrowers handing the keys back to lenders, short sales, note sales and foreclosures.
“One of the challenges we’ve had is that the lenders are still kicking the can, but within the past three to six months, we’re seeing lenders realize that they may just have to sell the note at a discount rather than go through a foreclosure process or an amendment process,” says Gorin.
Barings expects short sales to be a much more active channel for acquisition opportunities going forward, as unwinding those loan maturities will be a lengthy process that could stretch over the next three years, and potentially longer. “We’re at the very beginning of it. So, we’re willing to be patient to find the right deals,” says Gorin. “There’s going to be a lot of ‘have-not’ opportunities that I just wouldn’t touch. But I don’t think this is going to be a rush to the exits for the banks. It’s just going to take a while to unwind.”
Another positive note for prospective buyers is that the overall lending environment is showing some signs of improvement. “The CMBS market is significantly more active, even for some office deals, and there has been an influx of private capital which is trying to fill the gap left by large commercial banks that are still rightsizing their office portfolios,” says Durand. “With a more diverse set of market participants and ample capital, banks should start to see some loan payoffs. That could allow for at least some potential new office loan originations, and office real estate investors should start to see more debt capital available to take advantage of the positive trends currently developing in the market.”
Story first published in Institutional Real Estate Inc.