Why Office Now? Today’s commercial office environment is unique from prior cycles and will continue to afford opportunities to deliver outsized returns, even as the recovery time since the last recession is lengthening. Prime submarkets within fast‐growing Secondary Markets have recently overtaken 1 and are projected to outperform Gateway Markets 2 , making larger contributions to the overall performance within the office sector. Alpha‐generating opportunities are further extended through pro‐active leasing, property management, and asset management to drive NOI (Net Operating Income) growth. In this research piece, we will discuss how the current and forecasted office environment combined with well‐targeted locations, an expertise in selective office value‐add assets, and strategic improvements at the asset level present unparalleled opportunities for alpha‐generating office real estate investing. 1 Source: CoStar Analytics 2 “Gateway Markets” include New York, Washington DC, San Francisco, Los Angeles, and Chicago
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Why Office Now?€¦ · Why Office Now? Today’s commercial office environment is unique from prior cycles and will continue to afford opportunities to deliver outsized returns,
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Why Office Now? Today’s commercial office environment is unique from prior cycles and will continue to afford opportunities
to deliver outsized returns, even as the recovery time since the last recession is lengthening. Prime
submarkets within fast‐growing Secondary Markets have recently overtaken1 and are projected to
outperform Gateway Markets2, making larger contributions to the overall performance within the office
sector. Alpha‐generating opportunities are further extended through pro‐active leasing, property
management, and asset management to drive NOI (Net Operating Income) growth. In this research piece,
we will discuss how the current and forecasted office environment combined with well‐targeted locations,
an expertise in selective office value‐add assets, and strategic improvements at the asset level present
unparalleled opportunities for alpha‐generating office real estate investing.
1 Source: CoStar Analytics2 “Gateway Markets” include New York, Washington DC, San Francisco, Los Angeles, and Chicago
Executive Summary
The market for commercial office space is increasingly positioned to reward a value‐add strategy in fast‐
growing Secondary Markets. Bridge believes this sector presents an under‐appreciated opportunity to
“create alpha” at the asset level and generate above‐market returns due to:
Limited New Construction: In many U.S. office
markets, rents are 30‐40% below
“replacement rents,” presenting a substantial
barrier to new construction despite the
expansionary real estate cycle environment.
Constraints to construction—e.g., regulation,
rising construction and land costs, and lending
issues—are expected to keep supply tight in
the medium to longer term, rewarding well‐
positioned existing assets with higher rents
and net absorption.
Rising Demand: Demand for office space is
growing rapidly in Southern and Western
Secondary Markets. These markets
disproportionately import demand from other
metros, support existing company expansion,
and foster startup ecosystems, leading to high
tenant leasing activity and absorption.
Employment levels are expected to increase
3.3%+ per year in a number of Secondary
Markets versus 1.7% in Gateway Markets.
Attractive Price Points for Investments: Despite
strong demand, office assets in fast‐growing
Secondary Markets and their submarkets
remain at an attractive price point, in many
cases less than 50% of new asset replacement
cost. This has been due in part to a lagging
recovery from the global financial crisis and
delays by many larger investors in recognizing
the opportunity for outsized returns that
these markets present. The suburban office
market share of demand and transaction
volume has been rising and is expected to
remain stable or increase as the overall
market grows. Bridge Target Markets3 present
the benefit of higher entry cap rates combined
3 “Bridge Target Markets” include 25 Secondary Markets within the U.S. The list of these markets is provided in the appendix.
with stronger forecasted NOI growth. There
also exists the prospect of compressing cap
rates in these markets from higher demand as
more investors realize the opportunity and
start pursuing these markets for greater
investment yields.
Limited Risk Environment: Investment Risks
are mitigated by macroeconomic and
demographic trends. A slow recovery and
tighter lending standards over the last decade
suggest that this expansionary cycle may last
longer than previous cycles. Full employment
risk is similarly constrained by a rising labor
participation rate, meaning that office
demand can rise even in a sub‐5%
unemployment environment.
Value‐Add Opportunities: Although trends in
office space usage have driven a more dense
utilization of space and a reduction of 50‐
100sf per employee, these shifts present an
opportunity to value‐add investors who can
renovate buildings to fit modern tenant
preferences and capture the insights of the
WeWork office model in repurposing obsolete
spaces for common area amenities. By
repositioning assets and leveraging a robust
in‐house leasing and operating platform,
Bridge targets to maximize occupancy and
command higher rents from satisfied tenants,
driving NOI and higher returns for investors.
Supply Story: New Construction is Being Held in Check by Market Forces
Headlines about rising office construction are really focused on five markets that represent 50% of the
current new supply. These stories can be misleading if taken as a broad brush to paint the entire U.S. office
market. Although office completions have steadily increased from their historically low numbers in 2011‐
2013, this cycle’s peak year for completions (2017) will be significantly lower than even historical average
deliveries over the past 35 years, let alone peak deliveries from other cycles, which have been as much as
triple the 2017 peak delivery. Furthermore, new completions are slated to come down again from 2018‐
2021.
Source: CoStar Analytics, Q1 2017
Why such low new construction during a time when absorption has outpaced completions every quarter
for the last 27 quarters, rents have increased, and vacancies have fallen? There is one main reason:
Builders Cannot Make Money Building New Commercial Office in Many Markets around the U.S.
Construction costs have escalated at a pace much faster than inflation and rents since the turn of
the century. RSMeans (a leading construction cost estimator in the industry) shows that
construction costs have increased 75% since 2000. With higher costs, fewer deals pencil (deals that
would have made economic sense in prior cycles). This escalation in costs is due to new regulations
in construction methods, higher labor costs (many construction professionals permanently left the
industry during the Great Financial Crisis), higher materials costs (in part due to global demand for
building materials in other property types), significantly higher municipal fee structures, and most
recently, lending regulations that make construction financing costlier and less desirable to banks
who have provided the majority of the leverage. All of these hard and soft costs, combined with
the high cost of land, have resulted in very little new speculative office construction in many
markets around the country.
0
50
100
150
200
250
300
Square Feet (in m
illions)
NEW COMMERCIAL OFFICE COMPLETIONS (U.S.)
New Office Completions Historical Average
3
This lack of new construction in most metro areas benefits owners of existing commercial office space in markets with growing demand.
Manhattan, 13%
San Jose, 12%
San Francisco, 9%
Washington, DC, 9%
Dallas/Fort Worth, 7%
Remaining Metros, 50%
U.S. SHARE OF OFFICE UNDER CONSTRUCTION
Source: RS Means, CoStar Analytics
Office rents, although steadily increasing since their trough in 2010, are nowhere near
“replacement rents” in many markets around the country. In other words, office developers need
to achieve certain rents for deals to make economic sense. Many U.S. markets (including both CBD
and suburban areas of these markets) show current asking rents for commercial office space well
below (often 30‐40% below) the rents necessary to justify new construction. This is a unique
circumstance this far into an expansionary real estate cycle. The results are historically low new
office construction during an expansionary portion of a cycle, with half of that construction in only
five markets nationally where “replacement rents” are high enough to justify new construction.
Source: CBRE Research, Q1 2017
80
100
120
140
160
180
OFFICE CONSTRUCTION COSTS VS. RENTS
Avg Office Construction Hard Cost Growth Avg Office Asking Rents
4
Demand Story: Office‐Using Employment is Expected to Continue its Strength
A slow and methodical economic recovery has led to steady employment growth and, more specifically,
office‐using employment growth since the second quarter of 2010. The slow pace of economic growth,
coupled with more restrictive lending standards relative to prior cycles, has allowed for a lengthening
expansion with major forecasters prognosticating continued growth for the next several years.
Source: Moody’s Analytics
Owners of office space are poised to benefit greatly from this expansion. Office‐using employment
increased by 129,000 jobs in Q1 2017, which exceeded the quarterly average of 120,000 jobs since 20114.
Of particular note is that the financial services sector added 41,000 jobs in Q1, the highest quarterly gain
since 2005. A resurgent financial services sector, along with a growing high‐tech sector, healthcare/life
sciences, business services, and creative industries in many Secondary Markets throughout the country,
are a boon for owners of commercial office space for both the near and medium term.