The Danger in Office-Market REITs

A year and a half ago, I wrote an in-depth article showing why the so-called recovery in the commercial office market was only an illusion. Wall Street and the pundits continued to proclaim the strengthening of the office market. For example, the chief economist of the highly respected data firm, Reis, declared last October that in spite of stubbornly high vacancy rates, the recovery in the office market was “gathering pace.”

With weakness becoming more and more obvious in several of the hottest office markets, here’s why large office-market REITs are substantially overpriced.

Investor complacency continued unabated last year

As commercial real estate sales soared in 2015, so did the optimism of investors. In its mid-year Investor Outlook, Preqin reported that 57% of large investors surveyed had a positive perception of the real estate asset class, up from only 37% six months earlier. Only 6% of them had a negative view. Nearly 80% of them intended to commit the same or more capital to real estate over the next 12 months.

This chart from Real Capital Analytics shows how buying has soared.

Office-Market REITs
Office-Market REITs

Source: Real Capital Analytics

By the end of 2015, total commercial real estate sales had almost returned to the levels of the peak bubble year – 2007. The sales growth of 2013-2015 was almost identical to that of 2005-2007. Sales of office buildings in the U.S. climbed to $146 billion in 2015, 40% higher than in 2013. In my 2015 article, I pointed out that nearly half of the total dollar volume of office sales in 2014 occurred in just five major markets: Manhattan, Boston, San Francisco, Los Angeles and Washington, D.C. The same domination by these markets continued last year. If we add one more metro – Silicon Valley – these six accounted for more than 50% of all nationwide sales.

As in previous years, the Manhattan office market towered over all others with nearly 20% of all U.S. sales. Its price per square foot was hundreds of dollars greater than any other metro. Foreign investment as well as institutional money poured into Manhattan, especially in the high-tech area known as Midtown South. Prices soared well above the former peak levels of 2007. Chicago was a distant second with a mere 6% of total sales.

Is it possible that this time, things really are different?

What has happened in the hottest real estate markets?

Real estate busts nearly always begin in the hottest markets. Quite unexpectedly, not enough optimistic buyers bid on the huge supply of properties that are offered by sellers. Prices begin to flatten out as sales weaken. Sub-listing of space soars just as a lot of newly built office space hits the market. Empty space stays on the market longer as prospective tenants balk at the lofty rents still being asked.

 

The cooling of San Francisco and Silicon Valley

Other than Manhattan, the San Francisco Bay area has been the hottest commercial real estate market in the country. San Francisco real estate is inextricably tied to what is happening in Silicon Valley. For nearly five years, that has meant the five giants: Apple, Google (now Alphabet), Facebook, Netflix and LinkedIn.

Since 2010, these five companies have leased half of all new office developments either completed or under construction in Silicon Valley. According to Newmark, Cornish & Carey, there is 9.4 million square feet of office space under construction now.

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