Investors Don't Fear Vacancies

CHICAGO—As bid-up pricing results in lower returns, especially in prime office markets, investors are turning to a new strategy, according to Transwestern's Gary Nussbaum. That is, they're becoming more opportunistic, buying buildings with substantial or total vacancies.

It's not only the lower returns on stabilized assets that have motivated investors to accept more risk—and, often, pay higher prices on vacant, nearly vacant or soon to be vacant office properties, writes Nussbaum, Chicago-based managing director, investment services. They're also finding more debt sources willing to lend on opportunistic deals.

“In order to increase their returns, some lenders have been willing to finance the acquisition of vacant buildings, offering interest-only, debt fund financing at 65% loan-to-value” as well as providing 100% of the cap-ex funding, Nussbaum writes in a special report. Interest rates, meanwhile, have been as aggressive as sub-6%. “Terms are improving because more debt sources are loaning on these non-core assets.”

As for core office assets, Nussbaum notes a negative correlation between returns and markets seeing the most economic improvement. That's especially true in technology and healthcare hubs experiencing strong job growth.

“Driven by competition among investors, cap rates on the best office properties in the top six US markets have fallen to an average of 4%, down almost 50 basis points in 2014, according to Real Capital Analytics,” observes Nassbaum. “Prior to the past two years of economic recovery, investment returns had declined for other reasons. In a flight to quality, risk-averse investors increased their allocations in real estate assets, whose returns were outperforming other fixed-income assets.” In the current environment, of course, seemingly everybody is in hot pursuit of those low-risk—and, increasingly, low-return—deals.

Along with the attractive financing terms now available for non-stabilized assets, investors are drawn to vacant office properties because of their potential for repurposing. “Office space in many major metros has been creatively converted into multifamily units, hotel rooms and retail space,” according to Nussbaum. “The trend is especially prevalent with functionally obsolete office buildings located in urban, transit-oriented areas.”

A case in point is the 388,000-square-foot office building at 311 W. Monroe St. in Chicago. The property was built in 1969 as the headquarters of BMO Harris Bank, which vacated 250,000 square feet this past December. “Even so, the 15-story asset sold in fourth-quarter 2014 for $58 million to buyers that knew it would be 82% vacant,” Nussbaum writes.

As GlobeSt.com reported last month, the buyers of 311 W. Monroe were a joint venture of Prudential Real Estate Investors and GlenStar Properties, who plan a repositioning with a multi-million-dollar capital improvement program. Bearing out Nussbaum's point about lenders being willing to finance deals of this type, Mesa West Capital provided $68 million in first-mortgage debt to the JV.

When we see an increase in interest rates and a tightening of lending standards, then the empty-building trend could go by the boards. Until then, Nussbaum writes, “Transwestern anticipates an uptick in the acquisition of vacant, opportunistic buildings as returns in the core and value-add space continue to decline.” Additionally, “as existing owners realize there is a growing interest in non-stabilized properties, more of these opportunistic assets are expected to be brought to market.”