Hidden Gems: Flight to Quality

Commercial real estate investors perpetually seek indicators for signs when, and in which asset class, the market is poised for new opportunities. However, by the time these signals are realized by the masses, it is already too late as the optimal moment to take action has passed. Analyzing historical patterns from the recovery cycle of larger U.S. markets reveals the potential for hidden gems—high-quality, but high-vacancy properties—that may be discovered ahead of the curve in secondary or tertiary markets such as Southwest Florida.

According to CBRE Econometric Advisors, office demand in the U.S. has strengthened in recent quarters; vacancy rates in a majority of markets have already come back down from peak levels. In some areas, however, there is still a lot of space to be absorbed in order to bring vacancy rates back to their cyclical norms. Just as some markets forge ahead while others lag, there is also differentiation in performance across the quality spectrum of office assets. In most markets, the assets that lead the recovery tend to be those of higher quality.

This fact is not surprising: firms that produce high-quality products tend to recover sooner and outperform those with lower quality products due to stronger demand for superior goods (i.e. Apple Computers versus Hewlett-Packard, or Audi cars versus GM). An investor might think about demand for office space in the same way that consumers

regard goods from different manufacturers. Tenants will seek out the highest-quality space for the cheapest possible rents when looking to locate their business. When office space is needed following a downturn, Class A space is typically the first to be absorbed, given the combination of high quality and relatively lower costs.

The chart below shows historical vacancy rates achieved by both Class A and Class B buildings in downtown major markets of the U.S. following the previous three recessions. After the early 1990s recession, Class A assets came down from peak vacancy rates a few quarters sooner than Class B assets did. You will also notice that during the period between 1993 and 1999, Class A vacancy falls more rapidly than Class B vacancy. Not only did vacancy reach its peak and reverse sooner in these assets, but it also declined at a noticeably quicker pace.

Class A Downtown Office Vacancy Comes Down from Peak Sooner and Faster than Class B

A similar situation can be seen in the 2000 recession, though the swing is much less volatile. Class A buildings again peaked a few quarters sooner than Class B. As for the most recent recession, we can see that, since 2010Q1, Class A assets have already come well off of their peak levels, while Class B assets are still hovering around theirs.

Two main reasons for the rapid absorption of Class A space are the high demand for a quality work environment and a historical volatility in rents. Because Class A rents are a bit more volatile than Class B, during a recession quality space can become relatively cheap compared to pre-recession highs, making Class A space look a lot more attractive. And post-recession, Class A space reaches and surpasses its previous peak rent levels sooner.

Although it may seem obvious that higher-quality assets are going to outperform the market, the argument here is that they lead the recovery by leasing up quickly and returning to a once profitable investment in a shorter amount of time. Now although many of the larger cities have already seen a turnaround in vacancy, many opportunities related to yet-to-be-realized turnarounds remain. Some of the West Coast markets, including those most beaten down by the recession and housing crisis, will have a slower recovery to leasing up space, since companies are still consolidating office space. The slower recovering markets will also include markets that typically see less trading activity in general. Listed below are several markets—including one in Florida—where vacancy has not yet turned around, but is forecasted to peak within the next three quarters.

Market Vacancy Peaks in the Next Three Quarters

Within these markets still in the midst of recovery lie assets we call “hidden gems”. Since the lease-up phase has not yet accelerated in these areas, the higher-quality buildings will pick up tenants much more quickly and begin outperforming the market as demand ramps up. These assets will surely lead the markets in their recovery, and there are plenty on the market with higher-than-average vacancy, where lease-up will add a tremendous amount of value, although investors in Class A assets should be aware of the potential risks of negative rent volatility during a down cycle.

CBRE-EA concludes that now is a perfect time to look for these leading assets before they break away from the market and away from their peak vacancy. The Southwest Florida market offers an opportune environment to uncover such hidden gems. The quality assets will continue to lead the market as they have historically, they will hedge against spikes in vacancy during tumultuous economic times, and they will see the highest tenant demand among the assets in their areas. Southwest Florida should be no exception.

Stan Stouder is a founding partner of CB Richard Ellis, Fort Myers/Naples and a speaker at the annual News-Press Market Watch real estate symposium. Contact him at stan.stouder@cbre.com

Posted:  News-Press.com 7-16-2011