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REITs Turning to Office Properties for Future Growth

Surge in Office Buys Follows Moves by Investment Trusts to ‘Harvest Returns’ by Selling Other Property Types

The nation’s equity REITs are selling more property this year than they are buying compared to the past couple of years. In fact, they have already become net sellers of industrial properties.

Notably, however, the REITs are pivoting their investment strategies to increase their office property holdings at a faster rate than they are selling them. The spread has almost doubled so far this year compared to last year.

The pattern signifies what is happening across the REIT investment spectrum this year, according to Dennis Duffy, managing director of Landauer Valuation & Advisory Services, a division of Newmark Grubb Knight Frank in Washington, DC. Increasingly, Duffy said, REITs are turning to invest in office property as they ‘harvest returns’ by selling other property types in the current low cap rate environment.

“The trend is being precipitated by the desire for secure yield,” added Duffy. “Suburban office acquisitions are now considered ‘value-add’ properties, in many cases. Alternatively, CBD office properties offer secure, stable cash flows. And, especially regarding suburban office buildings, REITs do not want to sell at prices lower than historical acquisition basis. They will tend to hold and re-tenant buildings more often than institutional owners.”

John F. Myers, managing director at Cassidy Turley in Bethesda, MD, is seeing the same trend.

“REITs are looking to bolster the quality of their portfolios. They are selling industrial (because it is a seller’s market) and buying into office where they can be all-cash buyers and leverage the asset at a later date, thereby allowing them to make cleaner offers more certain to close,” Myers said.

According to analysis using CoStar COMPs, last year, REITs acquired twice as much property as they sold. This year, the difference between their buying and selling activity has been cut in half. While the pace of acquisitions is almost even with last year; the pace of REITs selling properties is up almost 25%.

However, analyzing REIT sales activity by property type, the reverse is happening in the office sector. Office property purchases are up nearly 37%, while office sales are holding even.

Capital Markets Conducive To Investment Trends

Jason Bates, vice president of investments at Parkway Properties in Orlando, explained that current capital market trends are conducive to the strategy.

“REITs have generally felt comfortable paying today’s market prices given the stability of the assets and the cost to replace these assets,” Bates said. “Generally, REITs are still buying below replacement cost and are able to finance them effectively,” Bates added. “In addition, REITs are generally able to buy without financing contingencies, which is attractive to many sellers. This is because the debt market has still been very discerning of the borrower when making asset specific loans.”

The trend is also logical from a long-term fundamental perspective for REIT’s, added Tyler Boyd, market research analyst at Voit Real Estate Services in Roseville, CA.

“If you look at the three (major) sectors of commercial real estate (office, retail, and industrial), office is the sector that has the least risk to dramatically evolve over the next 20 years,” Boyd said. “Industrial continues to evolve towards the big-box, modern distribution age; and retail, as always, evolves with the consumer and has become a game of seeing which retailers can become the most e-commerce resistant.

“Office has actually evolved little over the last 50 years, other than relatively smaller floor plates and greener buildings,” Boyd added. ”This provides REIT’s with the assurance that if they buy a newer, LEED building their income stream over the next 20 years should be fairly safe. Combine this with the fact that the office sector has been the last sector to recover from the recession, especially in the suburban and tertiary markets.”

Brian Merzlock, real estate strategist for Williams Auction, a division of Williams, Williams & McKissick in Tulsa, OK, has noticed that REITS are particularly keen on medical or tech office space.

“Most REIT managing members are seeking high-end office space (as well as multifamily and retail candidates) – properties ideally located in ‘money districts,’ inside the beltways, or within walking distance to key metro linkages,” Merzlock said. “Key indicators for most REITS include cap rates, NOI and low vacancy (below 15% to 20%).

“Another key factor to understanding the surge, is the thinning of the trees in the forest that is occurring with an increasing number of REIT mergers occurring where millions of square feet can be represented in one merger/acquisition… some of the largest recorded sales prices of late have occurred via mergers,” Merzlock added.

Another driver of the current REIT investment pattern is that many REITs are in a realignment stage during which they are disposing of non-core assets, while striving to get back to core competencies and markets.

For example, that’s the case for Tier REIT (formerly Behringer Harvard Real Estate Investment Trust I).

“I believe this trend is a result of REITs having capacity to grow after shoring up their balance sheets and feeling less uncertain about the direction of the economy,” said Scott Fordham, president and CFO of Tier REIT. “Throughout 2013, prior to the [federal government] shutdown, the economic angst had waned somewhat and as a result, we, and I believe REITs in general, have been increasingly more comfortable underwriting rental rate growth in markets where new supply has been held in check.

“Provided the dysfunction in [Washington] DC, [politics] does not result in the economy losing its foothold on recovery, we believe we will be in a position to continue to underwrite rental rate growth and make investments that meet our return thresholds,” Fordham continued.

This week, Tier REIT agreed to sell to an unnamed buyer 10 and 120 South Riverside Plaza in Chicago for a contract sale price of $361 million.

Source: CoStar Mark Heschmeyer October 9, 2013
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