Office Cap Rates Fall Flat

Office cap rates may be about to hit a wall, according to the first quarter report from Avison Young. The report—which showed a rocky first quarter with 426,000 square feet of negative absorption and a 14.5% overall vacancy rate in Los Angeles—predicted a flattening of cap rates in office over the next 12 months due to rising interest rates, higher treasury bill rates and the slow rate of inflation, according to the report. To find out more about this emerging trend and how it will impact investment activity in Los Angeles, we sat down with Jonathan Larsen, principal and managing director at Avison Young, for an exclusive interview.

GlobeSt.com: Why are office cap rates expected to flatten this year?

Jonathan Larsen: We can’t logically see how cap rates could continue to go much lower in most of Los Angeles’ office submarkets. The underwriting and financial analysis from institutional investors is already pushing the limits when it comes to expected rent growth and rent expectations.

GlobeSt.com: Which L.A. submarkets do you expect to see this in, and why?

Larsen: Although the Westside has been one of the best performing markets across the nation for several years, we expect to see cap rate flattening here. The majority of Westside office submarkets, including Santa Monica, Beverly Hills and West Hollywood have been at incredibly low cap rates ranging from approximately 2.7% to 5.25%. Higher interest and T-Bill rates and slow rate of inflation are all bigger picture fundamentals that factor into this trend.

GlobeSt.com: How will this impact office investment activity in Los Angeles?

Larsen: We don’t see this having a negative impact on investment interest as the L.A. economy is doing quite well with a 4.1% unemployment rate. Companies continue to be attracted to the area for its unique access to a valuable talent pool with top tier universities and one-of-a-kind employers that can only operate here in the L.A. basin. A couple of these main industries include media curation and commercial space launch and exploration. Also, as Chinese investment has appeared to have curtailed somewhat, others have come in to fill in that space such as Canada, Japan, and other Pacific Rim, European and Middle East funds.

GlobeSt.com: What is your advice to office investors looking to buy this year in L.A.?

Larsen: There is no time better than the present to invest. However, there are fewer and fewer opportunities left for solid recession-proof L.A. assets that are poised to weather the next downturn—or at least be somewhat risk-averse – in choice office submarkets. Most of the opportunities we are seeing now are value-add properties versus core assets so if something does become available that is a good fit, a quick decision process is important. We have to keep in mind that the post-recession cycle is nearing a decade at year-end.

GlobeSt.com: The first quarter office activity was off to a rocky start with negative absorption. What is your outlook for lease activity for the remainder of the year?

Larsen: One quarter of negative net absorption doesn’t make a trend, so I don’t see a cause for concern, especially given the reasons previously mentioned: a strong local L.A. economy with regards to specialized STEM industries that are curating original technologies unique to L.A. They cannot be replicated or transplanted anywhere else. Also, historically, the first quarter or two of a new year typically produces the weakest net absorption (chalk this up to uncertainty of a new year’s start). The outlook should continue to be positive for L.A. barring any major global financial crisis or geopolitical turmoil. With employers continuing to hire and business activity very active, that should also translate into powering local office leasing activity.