Ares Real Estate and RXR Realty, which last week announced plans for a $500 million joint venture targeting New York office properties, will invest across the capital stack in class A- and B+ properties.
The firms launched the joint venture with investment convictions that include a long-term belief in the future of New York as well as a world in which demand will rise for well-located, amenitized office space, said David Roth, co-head of Ares US Real Estate.
“While New York may be having a difficult time now, we strongly feel it is going to be a good place to invest capital. We believe in New York and believe in at least some of the office space,” Roth said.
The venture likely will not consider the highest echelon of properties, which Roth noted are performing incredibly well and seeing peak market rents. Instead, Ares and New York-based manager and investor RXR will be looking at buildings in what Roth characterized as being in the 70th to 90th percentile.
“These are assets that have declined in value and you’re in a world where there is limited, if any, financing available,” Roth said. “We think we can be flexible in how we invest in the capital structure. We can provide different solutions depending on the need, including doing a joint venture with a bank or with an owner on a preferred equity position.”
Roth drew a parallel between the office sector today and the impact of e-commerce on the retail sector.
“Some retail became obsolete,” Roth said. “Some office will be obsolete. But there is still a need for people to go into brick-and-mortar retail, just like there is a need for people to go into the office.”
Scott Rechler, chairman and chief executive officer of RXR, noted the venture sees a clear opportunity.
“With less liquidity in the market, and lenders actively seeking to reduce their exposure to commercial real estate, owners of Class A office buildings have had less access to capital than before,” Rechler said. “We target good buildings with broken capital structures.”
Bigger picture trends
The Ares-RXR venture comes at a time when transaction activity in the city has started to tick upward and capital is starting to move. SL Green Realty Corp, a New York-focused office real estate investment trust, announced plans to launch a targeted $1 billion debt fund for properties in the city. Additionally, veteran lenders and investors Ethan Penner and Chad Carpenter have rolled out Reven Office REIT, a planned financing-focused company which will take a national view of the sector.
Michael Lee, a partner at HKS Real Estate Advisors, said the New York-based advisory firm has seen an uptick in transaction activity over the past two months as sponsors realize they are up against near-term loan maturities.
“People are realizing rates are not likely to go higher and they should be starting to look at opportunities to re-enter the market as things start to improve,” Lee said. “Distress is starting to pop up here and there in a very specific, case-by-case way.”
Despite this anecdotal evidence, the firm’s full-year 2023 report on the New York investment sales market tracked full-year transaction volume of $16.66 billion, a 40 percent drop from 2022. The gap stemmed from what HKS believes is a bid-ask spread between buyers and sellers driven by higher interest rates. The firm has been seeing lenders cooperating with extensions or modifications, but this ultimately will end, Lee said.
“Even if someone sees the light at the end of the tunnel, sometimes they’re thinking, ‘I can’t make it’ and they will start to look for solutions,” Lee said. “Loan maturities will start to drive these transactions and we are already starting to see clients come and say they’re considering a refinance or a sale but not sure how to go about it. We are starting to help them work through that decision-making process.”
Investment thesis
Ares has been active in New York for many years, with Roth citing a long-term relationship between the alternative investment manager and the real estate investor and operator as a key factor in the venture.
“A critical aspect of doing a deal like this is having a partner who has a good reputation as a manager and owner of office buildings,” Roth added. “Every deal you look at is going to somehow involve a bank or other lending entity and it is important to have an operator who has done the right thing.”
Roth continued: “That doesn’t mean not handing buildings back because when you have a change in valuation as significant as has occurred in as short of a period that has occurred, anyone active in the office space will have deals that have not worked.”
The office sector is in a period of flux, with the needs of end-users evolving as corporations work to figure out their space needs.
“There may be a pendulum swing back from the overshooting in the cutting back of space,” Roth said. “In the background is the question of, ‘Is office still viable at all?’ But by definition, we don’t believe office goes away.”
He continued: “You can’t make a commitment to this kind of strategy if, at the core, you don’t believe it is hard to run most businesses when most people are sitting at home and potentially working different hours.”
According to Rechler, many lenders and institutional investors see office buildings as toxic, which creates an even larger gap in liquidity.
“The office market is undergoing an existential structural shift that the industry hasn’t faced since the early 1990s. With the acceleration of hybrid work, there is an increasing flight to quality for well-located office buildings with high-end amenities,” Rechler said. “This shift has only been exacerbated by a lack of liquidity in the credit markets, as banks have increasingly sought to limit their exposure to commercial real estate, which, in turn, limits the amount of supply of buildings that are increasingly sought after by today’s tenants.”
With its flexible approach, the venture has the ability to acquire debt from lenders, purchase buildings or provide “good news” money to owners that need capital to fund leasing or building upgrade costs, Rechler added.
“The office market isn’t dead – it is evolving, and the office will continue to serve a prominent role in the future of the workplace. The RXR/Ares joint venture will provide building owners with the critical capital and resources to position their buildings for success moving forward,” Rechler said.
The data story
Recent reports on New York’s office market paint a nuanced picture which reflects strong demand in certain parts of the market, with commensurate pockets of weakness.
Cynthia Wasserberger, vice-chairman at real estate advisory JLL, said the firm is tracking a strong flight to quality in Manhattan’s office market. The firm completes an annual report on premium leases signed at a level of more than $100 per square foot and tracked 192 leases totaling roughly 5.6 million square feet of leasing volume that fit this bill in 2023.
Of that, 55 percent were new leases and relocations, which demonstrated tenant interest in moving toward the strongest- and best-located properties in the city. Twenty percent of these properties had dedicated outdoor space, JLL found.
“The top-of-market buildings have tended to be the healthier ones and while they are not immune from some of the broader fragility in the market, these buildings out-performed,” Wasserberger said.
Total leasing activity throughout Manhattan was just over 21.7 million square feet in 2023, a 17 percent drop from 2022. JLL also found that 26 percent of the overall leasing activity in the city was for deals of more than $100 per square foot. “This level of leasing is now a meaningful component of New York’s leasing DNA and that a flight to quality and newness is very pervasive,” Wasserberger added.
While age and location matter to tenants, vintage buildings can also outperform, Wasserberger said.
“[This is the case] if the owner has addressed some of the qualitative features tenants desire, like thoughtful amenities and curb appeal, or the ability to have something that augments the workday,” she added.
Even amidst the current flight to quality, Wasserberger cautioned that it is critical to think down the line. Per JLL’s research, new development delivery has fallen and there is less than 15 million square feet of new space expected to be delivered over the next five years – a 66 percent decline over the past five years, she added.
“The top-tier deal subset is getting increasingly restricted in terms of availability. The development pipeline has been curtailed and soon we are going to see a shortfall,” Wasserberger added. “With the high-end leasing being so robust and the dearth of supply in that sector, we should be mindful that there will be a trickle-down and some of the buildings that are not A-plus buildings will reap the rewards of a push down into the commodity market.”
She continued: “As we look ahead, tenants will continue to look at New York as a relevant market and will continue to want to pay for good space. The relocations will be fueled by strong concessions. There should be enormous benefits to owners who can update or renovate properties to reap the rewards.”
Outlook
The distress being seen in the office sector today has been widely analyzed but is also different to what has been seen in other parts of the market.
“During the pandemic, the hospitality sector was deeply affected by lockdowns, but the distress never really materialized. Carry costs were close to zero and people were willing to place a bet that there would be a recovery,” Roth said. “Office today is different because the cost of carry is high, not just because of rates, but because you’re constantly putting money back in. As a result, the outlook for recovery of value is much more dire.”
In Roth’s view, the market is in the first stages of moving ahead on office properties.
“After many years in the market, you start to develop pattern recognition around when there is an inflection point in values,” Roth said. “The immediate effect is that all transactions stop because owners want yesterday’s price and buyers want the price that reflects the future. Across the board, people say, ‘I don’t want to sell my building at today’s price because I believe it will recover in value, so I’ll take structured paper today to satisfy whatever needs I have. And then, when enough time has passed, then the true equity pricing kicks in. But the first thing that happens is the infusion of gap capital.”
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