Small Office Markets Gaining Stature

The Torto Wheaton report notes that these smaller markets, while not yet having the same economic stature or demand for commercial space as New York, Boston or Chicago, still combine to hold 45% of the US population "and a growing share of the nation's commercial real estate." These smaller markets "are attractive to investors for their concentration of economic activity and employment, which results in attractive income and asset appreciation opportunities for their investments," the report states.

The report refers to the smaller cities as "Tier II" office markets. They range from the smallest in Janesville, WS with a population of 60,000 and 1.1 million square feet of space, to Milwaukee, with more than 41 million square feet of office space.

Despite their smaller size, the Tier II cities are generally expected to outperform Tier I markets in terms of rent growth projections over the next two years, according to the report. Among the reasons for these rent projections are the generally lower level of speculative development in the smaller cities--because developers tend to focus on larger markets.

One effect of this lower level of speculative development is that the office space in the smaller markets is less likely to become overbuilding, which "shields them from the rates of rent decline seen in larger markets" during a recession, the report points out. The lack of speculative development generally produces a steadier, more stable rent growth pattern than in major markets during periods of expansion, "which in some cases can moderate the impact of economic downturns," Torto Wheaton points out. As is explained below, however, the smaller markets are subject to statistical volatility because the impact of large deals can be so great.

In comparing office market performance between small and large cities, the report notes some differences between the two types of markets within various regions. It shows that the northeastern Buffalo market, though much smaller than Boston, outperformed its regional neighbor to the east in terms of asking rent growth and vacancy rates. Rents grew by more than 4% in Buffalo and fell by 1.7% in Boston, while vacancy rates dropped by 40 and rose by 20 basis points, respectively. "Hypothetically speaking, an investor with assets in Boston could have possibly offset some of the loss in rental income by diversifying his portfolio with investments in Buffalo," the report concludes.

One general contrast between the smaller and larger cities is that performance in the smaller markets "is generally more volatile," according to the study. It points out that this makes sense because large transactions in a relatively small inventory of space "can cause great swings in vacancy rates and rents."

As examples of this volatility, in the small market of Wilmington, NC, gross asking rent declined by 10.3% in 2008, while Raleigh's tech-rich economy provided enough growth for its rents to increase by 2.6%. This point out that "There is more risk involved with investing in small markets, making diversification even more critical," the report advises.

While smaller cities may not appeal to investors across the board, they may represent an investment alternative for those interested in mid-range to smaller markets," Torto Wheaton observes. Following this initial report on Tier II markets, the research firm promises more coverage of other small markets in coming quarters.