Office Sector Looks Forward to 2011

NEW YORK CITY-Leasing velocity and investment sales alike may be up, but the New York City office market will have to wait until at least 2011 to see a sustained improvement in fundamentals, says Marcus & Millichap Real Estate Investment Services. At the same time, opportunistic investors may find some bargains in the distressed arena, although by no means a glut.

In Manhattan alone, “more than $6 billion in office properties are near to or in default or special servicing,” according to a second-quarter New York City office report issued Thursday. The assets that fall into that category cut across class and location, notes Ross Mezzo, associate VP of investments with Marcus & Millichap’s New York office.

The properties that sold between 2005 and 2007, generally considered the “hot spot” for highly leveraged CMBS deals, “weren’t just class A trophies,” Mezzo tells GlobeSt.com. “Anything in a good location was selling: mid-block, Garment Center, Midtown South. As a result, the specter of loans coming due is widespread.

Yet when it comes to that era representing a future gold mine of distress, “I don’t think it’s ever going to come to what people have predicted,” Mezzo says. “It didn’t happen last year; there was a hundred zillion dollars on the sidelines waiting to buy Manhattan at a super-discount, and it never happened. It’s not going to happen.”

The Marcus & Millichap report notes that employers here began 2010 “at a sprint,” hiring 48,000 workers during the first six months and thereby laying the groundwork for an upturn in demand for office space. Nonetheless, the report states, “a widespread improvement in operating fundamentals remains unlikely” until next year.

The city is outpacing the US as a whole when it comes to reinstating jobs lost during the Great Recession. Twenty-eight percent of the positions citywide that were eliminated during the downturn have been restored, compared to only 16% of the national tally. Even so, the report says, “tenants relinquished 28 million square feet of office space in that stretch, while a considerable amount of space is leased but under-utilized and could hit the market in the coming quarters.”

As a consequence, Marcus & Millichap reports that the “mild vacancy decrease” recorded in Q2 is likely to give way to “a late-year uptick.” Meanwhile, however, “declining sublet space availability will underpin softer rent cuts this year. While office demand will not recover at the citywide level by year end, premier areas will record slight improvements.”

In the sales arena, while deal flow and prices remain low in the surrounding metro area,  “both activity and interest have begun to build for performing, trophy assets,” the report states. Adds Mezzo, “There hasn’t really been anything on the market for two years and there’s not that much inventory out there, so when these types of assets come onto the market, people are going to pay up.” He allows that while buyers haven’t necessarily been overpaying for the assets, they may be paying more than they would if there were a greater selection available.

Much of the activity year-to-date in the core assets segments has been sale-leaseback deals and partial-interest transfers, Marcus & Millichap says.  “This year, initial yields for these assets will average in the 5% to 6% range due to the large group of interested REITs, funds and foreign buyers,” the report states.

Both inside and outside of Manhattan, “prices for lower-tier office product will continue to fall” because rents at these properties will lag the overall economy in a recovery. “As such, local investors have found smaller and operationally sound buildings at attractive cap rates in areas such as Long Island City, northern Brooklyn and Flushing.”