Situs RERC Office Investment Conditions – 1Q 2017
The CRE market appears to be reaching the peak of its cycle, and many wonder when the office sector will see a turning point. Many factors, ranging from employment to the concerns of various demographic groups, influence the office sector.
Some believe that the emergence of autonomous vehicles or artificial intelligence will bring profound changes to office dynamics in the near future. Several firms are thinning their traditional workforce for more automated alternatives. As automation continues to gain traction, the needs of employers for traditional office space may be replaced by more integrated, multifaceted space. However, other companies are pulling back from these trends. International Business Machines (IBM) announced in spring 2017 that it is calling all of its remote employees back to its physical offices.
How is the office sector faring amid all these changes? Situs RERC surveys institutional investors quarterly to better understand the investment environment. Situs RERC’s survey respondents indicated that the office sector — in particular the suburban office sector — was the most susceptible segment of CRE to experience an economic downturn. But other respondents reported that there were good investment opportunities in central business district (CBD) office properties and high-quality suburban office properties during first quarter 2017. Respondents also noted that office properties were still trading below the peak, suggesting that there may be some room for price growth.
Amid all of this, the investment conditions rating for the CBD office sector increased to 6.4 on a scale of 1 to 10, with 10 being excellent, during first quarter 2017, according to survey respondents (see Exhibit 1). Notably, the investment conditions rating increased for the first time in two years. This was the most significant increase since first quarter 2010. The suburban office sector rating increased to 5.6 — the highest rating over the past three years — as respondents indicated that investment conditions improved.
Although investment conditions rose for the office sector, Situs RERC’s expected rental growth rate for the CBD office sector declined 10 basis points to 2.8 percent, while the rate for the suburban office sector was stable at 2.6 percent during first quarter 2017. Expected expense growth rates for the CBD and suburban office sectors increased to 2.8 percent
Situs RERC also surveyed institutional investors about required (i.e., expected) rates of return. Similar to most of the other property sectors, Situs RERC’s weighted average required pre-tax yield rate for the overall office sector increased 10 basis points to 7.8 percent during first quarter 2017 — the highest rate over the past two years. Likewise, the weighted average required going-in and terminal cap rates for the overall office sector increased 10 basis points to 5.9 percent and 6.6 percent, respectively.
The office sector’s spread between the required IRR (discount rate) and required going-in cap rate has remained fairly steady since the end of the recession (see Exhibit 2). This spread may be thought of as a signal of growth expectations for a particular asset, and a widening spread may indicate greater growth expectations. Since the beginning of 2009, the spread for the office sector has been around 170 basis points. However, after a period of narrowing spreads from second quarter 2015 through mid-2016, the spread began to widen again, reaching 190 basis points as of the first quarter of 2017, and is comparable to pre-recession levels.
Exhibit 2: Situs RERC Office IRR and Cap Rate Composition
Source: Situs RERC, 1Q 2017.
It is difficult to assess the future for the ever-evolving office environment. Values have continued to trend upward at a slowing pace, while total returns have been declining since early 2015. It may be too soon to draw any conclusions regarding the widening spread between the required IRR and required going-in cap rate for the office sector.
The timing of a potential contraction the office sector is open for debate. Some market experts feel that the office sector, like the larger CRE market, will see a slight dip over the next couple of years that is followed by a recovery and a further increase. Other experts believe that the office sector, similar to the retail sector, must remake itself to remain viable in an age of rapidly changing technology.