Office Sector Growth Spreads

Office sector growth is spreading to secondary and tertiary metros as the cycle matures, reported Institutional Property Advisors, Calabasas, Calif.

“Capital follows yield to smaller metros,” the IPA Office Investment Forecast said, noting primary markets including New York, Chicago and Atlanta have generated lower-than-average appreciation over the last 10 years, reflecting the “flight to safety” that started in late 2008 and kept pricing in large markets stronger than in smaller markets.

Secondary and tertiary markets’ higher cap rates have made investors increasingly open to assets in smaller metros, IPA said. “In fact, the increase in transaction velocity in tertiary markets was double all other areas on a percentage basis,” the report said, noting average cap rates in tertiary markets started 2019 in the mid-7 percent range, nearly 100 basis points above the primary metros’ average cap rate.

The report said this evolution is provoking urban renewal efforts in many smaller cities and encouraging some businesses to relocate from the suburbs to central business districts where once-struggling areas are evolving into more vibrant urban hubs. “Many office buildings have been given new life after the severe pressure of the recession and the soft years that followed,” IPA said.

Primary markets captured 45 percent of the jobs created in 2012 during the growth cycle’s early stages, the report said. Tertiary metros generated only 34 percent of new jobs that year. But by 2017 and 2018, those metrics changed in favor of tertiary markets. This trend will likely continue as more companies add facilities in smaller cities to capitalize on local talent that is unwilling to relocate to large cities, IPA said. “This trend will bolster office space demand in secondary and tertiary markets,” the report said.

The report predicted office construction will level out this year after increasing for the past two years. “Developers will continue concentrating more on central business districts, particularly in secondary markets where demand for downtown space is quickly rising,” IPA said.

Plentiful debt financing remains available from sources including local, regional and national banks, insurance companies and private capital funds but lenders remain “cautious” in underwriting despite the market liquidity, IPA said. “Loan-to-value ratios are typically in the 55 to 75 percent range depending on the borrower, asset and location,” the report said.