Non-Gateway Office: A Better Bet Than It Seems

LOS ANGELES-It isn't news that low yield expectations and aggressive pricing on core office assets have some investors looking for opportunities outside of the gateway markets. Yet a new white paper from CBRE recommends a balanced approach, rather than gravitating to one extreme or another. Its title sums up the argument: “Gateway & Non-Gateway Office Markets: From 'Either/Or' to 'How Much of Each?'”

The report, prepared by CBRE's US research team, including Christopher Macke, Jim Costello and Brook Scott, notes that “expectations of lax investor demand and anemic appreciation” are at the root of investor hesitation to invest outside the gateway office markets. Further, investors expect more downside volatility and less rental growth, thanks to the non-supply-constrained nature of non-gateway office markets.

“Investors associate lack of supply constraints with higher levels of volatility and a cap on the rental rate growth potential,” the report states. “This perspective has been widely held since the 1980s.”

A closer look, though, reveals that the perception of relative instability in non-gateway fundamentals isn't based in fact. Gateway office markets also were overbuilt during the aforementioned time period, for one thing. Additionally, in reality it's the supply-constrained markets that show more volatility, the report states. Yet the perception that non-gateway office markets are more volatile translates into significant pricing discounts in those markets.

“What if non-gateway office markets are now more similar to large-cap stocks than they are to gyrating small-cap stocks?” the report asks. “Yes, it is true that non-gateway office markets may exhibit slower rent growth. But if they are actually less volatile than conventional wisdom posits, then opportunities for higher yields may await investors without carrying the risks many expect.”

The gap between gateway and non-gateway fundamentals is narrower than many might expect, according to CBRE's report. Between 1992 and 2012, the average annual rate of completions in gateway office markets was 0.50%, while the average annual rate of net absorption was 0.90%. For their non-gateway counterparts, the figures were 0.80% and 0.77%, respectively.

“This is a surprisingly small difference,” the report states. “Is the superior ratio of completions to net absorption found in gateway office markets worth a 92-basis point pricing difference? On a 5% cap asset, this equates to more than an 18% pricing premium.”

Another surprise may be found in a comparison of the total returns for non-gateway office markets compared to gateway cities: the former are “actually slightly more stable,” according to CBRE. “While non-gateway office market total returns don't spike quite as high as those of gateway office markets, they generally also don't decline nearly as much during downturns. As a result, investing in assets in both non-gateway and gateway office markets could result in increased return stability, in addition to higher going-in yields.”

Accordingly, the report recommends that investors seek out the right mix of gateway and non-gateway assets “to achieve higher yields and capture reduced volatility.” However, the report adds, “timing is everything. If history is any guide, the spread between gateway and non-gateway office market cap rates will only compress as we move further into the economic recovery. The best time to invest in non-gateway office markets is when others are hesitant to do so.”