Commercial real estate investors are moving to smaller markets and buying suburban properties as they search for higher returns after snapping up the most desirable buildings in the biggest U.S. cities.
Demand for office buildings, retail centers and warehouses in cities such as Reno, Nevada; Greensboro, North Carolina; and Louisville, Kentucky, is surging as yields shrink for real estate on the coasts and in larger cities. Properties on the outskirts of major metropolitan areas also are attracting interest, with prices for suburban offices rising faster than downtown real estate, according to an index compiled by Moody’s Investors Service and Real Capital Analytics Inc.
“There’s plenty of capital for real estate,” said Jim Sullivan, a managing director at Green Street Advisors Inc., a Newport Beach, California-based property-research company. “If investors are in search of bargains, they do need to move a bit further out on the quality spectrum.”
Buyers competing for top-tier buildings fueled a real estate rebound in cities including New York and San Francisco, then moved on to secondary markets such as Houston and Portland, Oregon, and now are shifting their attention to smaller areas. The “low-hanging fruit” in the biggest cities already has traded hands in recent years, said Hessam Nadji, chief strategy officer at Marcus & Millichap Real Estate Investment Services.
“Yields in those markets have compressed pretty quickly,” he said in a telephone interview. “Investors seeking higher yields are going to secondary and tertiary locations.”
A survey released Thursday by PricewaterhouseCoopers LLP and the Urban Land Institute on trends for 2014 showed a rising level of confidence in markets outside of major areas as banks, insurers and private-equity firms prepare to increase financing to the sector. Wall Street may issue more than $100 billion in commercial mortgage-backed securities next year, which would be more than any period except the boom years of 2005 through 2007.
Real estate investors are “more willing to explore opportunities in a wider swath of potential markets,” according to the report, based on responses from more than 1,000 property buyers and lenders.
Commercial-property sales by dollar volume surged 222 percent in Reno in the eight months through August from a year earlier, and 173 percent in Louisville, according to New York-based Real Capital. Those gains beat the increases in Manhattan, where sales have risen 86 percent, and Los Angeles, Chicago and Dallas. In Greensboro, North Carolina, sales jumped 157 percent.
Reno’s industrial market has attracted Blackstone Group LP, the largest real estate private-equity firm, because of its proximity to Northern California and other Western states within a close shipping radius. In August, affiliates of Blackstone Real Estate Partners VII bought a portfolio of industrial properties in Reno from a partnership controlled by Lehman Brothers Holdings Inc., Lehman said in an Aug. 7 statement. Blackstone paid $427 million for the portfolio, according to law firm Willkie Farr & Gallagher LLP, which represented Lehman in the transaction.
Low property prices and interest rates have helped lure buyers to the market this year, said Tim Ruffin, a senior vice president at brokerage Colliers International in Reno.
“It really caught us all by surprise,” Ruffin said. “We’re recovering. Businesses are doing better.”
Reno-area office buildings of more than 40,000 square feet sold for about $200 a square foot from 2005 to 2007, during the boom, and fell to $100 a square foot from 2009 to early 2012, following the economic collapse, Ruffin said. They’re now selling for $110 to $140 a square foot, less than the $180 to $200 it would cost to build them, Ruffin said.
In Greensboro, the five-year average annual return for commercial real estate was 7.2 percent through the second quarter, and in Louisville it was 5.9 percent, according to the National Council of Real Estate Investment Fiduciaries, a Chicago-based trade group. That compares with a 0.8 percent yearly return in the New York area, and 4.6 percent in San Francisco. In September, the price per square foot for Manhattan office space was $678, according to Real Capital.
Smaller markets in parts of the Southeast are the investment focus for Highwoods Properties Inc., a Raleigh, North Carolina-based real estate investment trust with a market value of about $3.3 billion. Highwoods tries to invest in the best business districts of mid-tier markets, said Chief Executive Officer Ed Fritsch.
Highwoods is developing a $110 million two-building complex for MetLife Inc., the largest U.S. life insurer, in Cary, North Carolina, a suburb of Raleigh. In September, it bought the Pinnacle at Symphony Place, a 29-story, 520,000-square-foot Class A office building in downtown Nashville, for $153 million.
“Pricing is competitive,” Fritsch said of properties in the cities it’s focused on. “The gap between pricing in gateway markets and our mid-tier markets has certainly contracted.”
One advantage of investing in smaller markets is that rents are more stable than in large cities. While rents in New York have bigger jumps when the economy is thriving, they also drop more when times are tough, Fritsch said.
“The band of volatility is more narrow in the mid-tier markets,” he said.
Capitalization rates, a measure of yield for the real estate industry, for commercial properties in markets such as New York, Chicago and Los Angeles average 6.5 percent, Nadji said. In secondary markets including Portland they average 7.6 percent, and in areas such as Louisville they’re 8.6 percent. Cap rates are calculated by dividing net operating income by the purchase price for a property.
Blackstone is in talks to buy an office building in Lisle, Illinois, a suburb of Chicago, for about $115 million, said a person with knowledge of the situation. The purchase would be done at a cap rate of more than 8 percent, said the person, who asked not to be identified because the deal is private.
Rising investor demand for office buildings in markets such as Manhattan and San Francisco have sent cap rates down in the recovery as property values rose.
The three-month rolling average cap rate in Manhattan fell to a post-crash low of 4.7 percent in August 2012 from 6.4 percent in April 2010, according to Real Capital. In San Francisco, it dropped to 5.2 percent in August, the latest month for which figures are available, from almost 8 percent in July 2010, and in Houston it’s at 7.2 percent after climbing as high as 9.3 percent in June 2010.
Credit is becoming more readily available in smaller markets as the economy improves as well, helping boost real estate demand, Nadji said.
“It’s beginning to be pretty broad-based,” Nadji said. “Lenders are more willing to lend in tertiary locations for the first time, probably, since the recovery began.”
Banks have arranged $63.5 billion of CMBS this year, data compiled by Bloomberg show. Issuance is poised to reach $80 billion in 2013, according to Credit Suisse Group AG.
In the suburbs of major cities, office occupancies are being boosted by economic growth. Of the 56 million square feet that has been absorbed in the U.S. office market over the past year, 90 percent was in the suburbs, according to Walter Page, director of office research at CoStar Group Inc. in Boston.
With a lack of new development and a slowly recovering economy, some suburban markets may reach a point next year where they will have rent growth rather than rent declines, Page said in a telephone interview.
Price gains in a CoStar index that tracks large, high-quality properties have moderated in recent months as increases in another index that is dominated by smaller transactions has accelerated. That’s an indication “investors’ risk tolerance is growing,” CoStar said in a report. The study was based on data for commercial-property sales through July.
A Green Street gauge of U.S. properties was unchanged in October as higher interest rates “put the brakes on what had been a long-running recovery in property values,” according to a report last week. The firm’s index is based on its estimate of the value of portfolios owned by real estate investment trusts, which tend to have high-quality properties.
Green Street’s midtown Manhattan office price index was unchanged in October and is 10 percent to 15 percent below its 2007 peak, according to the report.
Not all real estate investors are looking beyond major cities. Since the financial crisis and ensuing recession, many REITs have been selling properties in smaller markets and focusing on the best-quality buildings in the most-desirable U.S. markets.
“The public REITs are not going to be buying in the tertiary markets,” said Rich Moore, an analyst at RBC Capital Markets in Solon, Ohio. “Investors don’t want them in it.”
Large institutional investors such as private-equity funds also don’t tend to have a lot of money invested in tertiary markets. In smaller areas, buyers are generally local or regional groups and closely held investors, said Bob Bach, director of research at commercial real estate brokerage Newmark Grubb Knight Frank in Chicago.
“Everybody’s searching for yield,” he said. “By and large, it’s a different investor profile that is attracted to tertiary markets.”
CommonWealth REIT, whose biggest shareholder is seeking to oust the board, has been selling suburban properties and buying in downtown markets. CommonWealth plans to seek buyers for 110 buildings in addition to 94 it has sold or has agreements to sell, the company said last month.
CommonWealth’s “success in reaching agreements to sell the 94 non-core properties listed for sale earlier this year, together with the substantially improved market to sell suburban and industrial properties, has encouraged our board to accelerate the sale of the remainder of CWH’s non-core properties,” Adam Portnoy, the Newton, Massachusetts-based company’s president, said in the Oct. 1 statement.
Hines Global REIT Inc., a nontraded REIT sponsored by international investment company Hines, this year bought a retail center in Jacksonville, Florida, for $135 million, and one in Murfreesboro, Tennessee, for $163 million, according to a regulatory filing. The 317,415-square-foot Markets at Town Center in Jacksonville is 93 percent leased, and the 747,497-square-foot Avenue Murfreesboro is 89 percent leased.
While Hines focuses on larger U.S. metropolitan areas, the company decided that the Jacksonville and Murfreesboro properties dominate their markets “and would command much higher pricing in larger markets based on the productivity of the retailers and the market share of the assets,” Kenton McKeehan, a Hines managing director, said in an e-mail.
Acquiring property in smaller markets has its perils. If the owner wants to sell in the future, the pool of prospective buyers may be more limited than in major markets, said Ryan Severino, a senior economist at real estate data provider Reis Inc. in New York.
“There’s definitely a liquidity risk there,” he said.
Rising interest rates may scuttle some planned property sales because of the additional borrowing costs. While rising rates are a risk for all real estate buyers, those shopping in small markets are likely to face fewer investors pursuing the same buildings, unlike in major markets such as New York and San Francisco.
“There isn’t as much competition,” Severino said. “Pricing is probably more reasonable in those markets.”