Near the beginning of the 1999 film Office Space, a cult comedy about mid-level employees languishing in thankless jobs, the protagonist's disgruntled attitude is cheerfully greeted with, “Sounds like somebody has a case of the Mondays.”
Since the prolonged recession of 2000 and 2001, the US office market has been exhibiting its own beginning-of-thework-week symptoms. Over the past several years, employment growth – one of the fundamental drivers for the sector – has been sluggish and business investment limited. Consequently, vacancy rates in many markets, until very recently, had been increasing and asking rents moving in the opposite direction.
For private equity real estate firms, these dynamics are not necessarily a bad thing – distress, after all, can bring its own set of profitable opportunities. But for many high-yield office investors, the problem they faced over the past several years was not weak fundamentals, but rather rising prices in the face of poor fundamentals caused by a glut of relatively cheap capital. For those office workers living in a cubicle, it might still feel like Monday, but for sellers of office properties, the past year has been one long, Friday-night happy hour.
Amidst this backdrop, Private Equity Real Estate invited four seasoned private equity real estate professionals to discuss the state of the US office market and their strategies for finding opportunities in today's environment. After a lunch of iced tea and gourmet sandwiches on the top floor of Morgan Stanley's Times Square headquarters – an appropriate venue, perhaps, given the expansive views of some of the world's most expensive office buildings – the conversation began.
While capital and competition are still rampant, the mood in the room was an optimistic one, buoyed by recent strength in the underlying economy and its positive impact on the US office sector. After years of relatively poor performance, it seems the market may finally be cresting the proverbial mid-week hump.
“As we look forward, we see more opportunities in the office space as leasing fundamentals are finally starting to pick up,” noted Russ Appel of The Praedium Group. “In the last three years predominantly, the flood of capital has lowered cap rates while leasing fundamentals – until six months ago in most markets – were really not improving. Now, we're starting to see some progress and that's kind of encouraging to us.”
Improving fundamentals and underlying economic growth were also cited by Michael Franco of Morgan Stanley and John Jacobsson of Apollo Real Estate as the basis for their positive view on the office market's recovery. And while the Fed's recent interest rate hike was a tempering factor to the group's confidence, it was nonetheless a relatively minor consideration, assuming that the monetary authority proceeds with restraint.
Though Frank Cohen of The Blackstone Group echoed the sentiments of his fellow participants, he also sounded a note of caution, pointing out the disconnect between fundamentals and pricing that has persisted in today's market: “We all rode this wave where fundamentals didn't do anything, but cap rates went down and multiples went up, so values really outpaced the underlying fundamentals,” he said. “So now the question is: Will the opposite occur? Will cap rates moving in the other direction outpace any pickup we have from increased absorption?”
Even with improving fundamentals, all four participants agreed that finding deals in today's crowded office market requires more effort and creativity than it did in the past. With real estate investors proliferating and capital easily available, opportunity fund managers are using all the tools in their arsenal to find and execute investments that can generate abnormal returns.
Jacobsson seemed to speak for everyone around the table when he noted how Apollo is approaching not just the office sector, but also the real estate market as a whole. “Over the last couple of years, we have become very single-mindedly focused in true value-creation style deals,” he said. “Rather than being a commodity player trying to outbid the next guy, we've tried to find very hands-on deals, such as an empty office building or the conversion of an industrial building into an office property.”
Although traditional opportunity fund “angles” such as finding assets at a discount to replacement cost and taking vacancy risk in certain high-growth markets continue to be important investment considerations, it is these types of “transformative,” labor-intensive deals that our participants agreed are necessary to deliver performance in today's market.
Morgan Stanley's Franco noted that while “we all get turned on by discount to replacement cost,” an important factor to consider is flexibility, particularly when it comes to monetizing an investment. “We look for opportunities that have multiple angles for execution other than just pure lease-up,” he said. “Looking at the deals we've done in the last year, they've all had multiple exit routes where there are different ways to make money.”
As an example, he pointed to a large office park in Atlanta that had been sitting on a significant amount of excess land. After Morgan Stanley acquired the property, the investors went through a year-long process to get most of the area rezoned as residential. They now anticipate they will be able to get most of their money off the table through the sale of the residential piece, leaving the office asset as upside.
Blackstone's Cohen and Praedium's Appel both seconded the attractiveness of having more than one exit, be it selling an office asset to its users, converting a portion of it to condominiums or breaking it up and selling off the pieces. According to Cohen, one of the central benefits of this flexibility is that “you can control your own destiny. If you're doing intensive asset management or leasing or changing the use, you can actively make decisions and roll with the punches, which is contrary to a stabilized building – that is what it is.”
And, as Appel added, “The problem with a fully-leased building – I hate to say it – but there's only one way to go. This whole group is used to the opposite.”
One of the thingsthis group has also gotten used to, particularly in the past couple of years, has been competition. One of the current themes of any real estate conference (or magazine, for that matter) is the flow of capital into the sector and the proliferation of investors, both new entrants to the market as well as more established firms looking to expand their investment strategies.
“In the past, value-added investors competed against each other,” noted Blackstone's Cohen. “Today they are competing against the core investors. So even if you find deals with hair on them, you're not really getting paid for the incremental risk that you take.”
Not only are opportunity funds going up against a broader range of office investors, they are also, in certain cases, competing against buyers from different property types. This is partially due to the types of investments opportunity funds are seeking – if a firm wants to convert, say, an existing industrial building into an office-condominium complex, they may face industrialand even residential-focused competitors – but it can also be chalked up to the robustness of the entire real estate industry.
In New York, for example, the point was made that you couldn't buy a piece of land to develop an office building – someone who wants to build a residential building would beat you on price. The same seems to hold true in other cities as well.
“Chicago is an example,” Jacobsson noted. “There is a rich history of talking about building the tallest building in the world in Chicago – it's been going on for 120 years since they developed the first skyscraper there. And right now, they're putting up two very large buildings, but they're both residential.”
As more competitors enter from the buy-side, high-yield office investors must also contend with more brokers and intermediaries entering from the sell-side. And as the digital age has allowed a broad electronic marketplace to develop, the sector's enhanced transparency and information flow make it much more difficult to find off-market transactions.
“By the time I get back to my office, there will be ten e-mails with regard to properties somewhere in the US that are now for sale,” Jacobsson said. “That is not necessarily a good thing.”
On the flip side, however, “It's a good thing if you're selling,” noted Appel.
Of course, one of the most competitive office markets in the country, and one the participants know quite well given the location of their own offices, is New York City. And with our panoramic views from the 41st floor – the Chrysler Building to the east and Central Park to the north – it was inevitable that talk would soon turn to the ground beneath our feet. And, perhaps just as inevitable, that talk would primarily concern the difficulty of finding attractive risk-adjusted deals in the Manhattan office market.
“New York is just much more competitive than any other market,” said Cohen. “You have the most equity players with the best financing and the most debt available. We're back to those times where a couple million dollars of equity can buy you a whole lot of building. So if you're being a disciplined office investor, it's very difficult to compete with someone who's playing with what is essentially an option.”
To underscore the competitive challenges that real estate investors face in Manhattan, Morgan Stanley's Franco discussed the City Investment Fund, a $900 million fund co-sponsored by New York-based real estate firm Fisher Brothers to invest exclusively in the city's five boroughs. Although the City Investment Fund has lower return thresholds than a typical opportunity fund, Franco noted that regardless of whether Morgan Stanley is investing via MSREF or the New York-focused vehicle, the landscape remains difficult.
“The capital markets have moved dramatically in the city,” he said. “It's tough to be an opportunistic player in New York.”
As the capital markets have become much more aggressive, another problem, particularly for opportunity fund managers, is the level of risk they must take on if they decide to buy properties. Whereas in the past, a vacant or dilapidated office building provided some upside if an investor could successfully implement their business plan, in today's market, according to Appel, much of the potential returns are being priced out of the deal.
“To buy a vacant building in New York City today, you have to pay a price as if it's leased,” said Appel. “Effectively, the seller is getting paid for the risk you're taking.”
Nevertheless, private equity real estate funds are still finding attractive opportunities for office deals in New York – they just might have to look beyond the borders of the five boroughs to do so. As an example, Jacobsson pointed to several office buildings that Apollohad recently purchased in Hicksville, Long Island, approximately 30 miles outside of New York City. The buildings were located right next to the local train station and the existing tenant, JP Morgan Chase, was vacating the premises, providing an attractive lease-up opportunity in a strong market.
“That's a metro New York deal from our standpoint,” he said. “Of course, it's not buying at 5th Avenue and Central Park South – or I should say Central Park West and Columbus Circle [the site of the Time Warner building, an Apollo investment] – but it's got attributes that you'd find attractive as an opportunistic office investor. And the price was great.”
Hicksville notwithstanding, the markets these opportunity fund managers are currently focused on lie much further afield of New York City. South Florida, given its attractive demographics and positive supply-demand fundamentals, is a region where all the participants have been active recently.
“Our strategy is heavily demographic driven everywhere in the country,” said Morgan Stanley's Franco. “Obviously you have to overlay pricing on top of that, but South Florida is a great market. We focus on warm weather locales because that's where population growth is.”
Blackstone, for example, recently purchased a 1.7 million square feet office campus in Boca Raton, Florida for approximately $193 million. In addition to the demographic appeal, other attractive factors cited by Cohen included the city's limited availability of land and a strict architectural review board, which helps to restrict new supply.
Praedium has also been an active buyer of Florida office properties recently – it purchased a 177,000 square foot business park near the Orlando airport for $17.3 million earlier this summer. In addition, the firm has been implementing a focused acquisition program in certain parts of the state that were dam aged by last year's hurricanes.
“One of the interesting strategies that we've been pursuing across asset classes, including office, has been in central Florida,” said Appel. “We've tried to identify properties that have some form of hurricane damage and that were not fully repaired due to a lack of insurance proceeds. We've been able to come in and buy these assets, renovate them and bring them back up to market.”
Jacobsson picked up on Appel's point, noting that Praedium's hurricane-focused strategy underscores one of the central themes for opportunity fund investors in today's real estate market, one that isn't just central to the state of Florida. He noted that you can take a macro approach to an investment, looking for strong demographic trends and supply-constrained markets where land will appreciate over time, “but if you can't find an angle – a way to get in on an opportunistic basis – then you've got a bunch of demographic reports and you haven't done any business. So taking the hurricane angle, for example, that's the kind of scratching and clawing you have to do in this environment to find the real turnarounds.”
Morgan Stanley's Franco concurred. “That's become even more paramount in the past four or five years,” he added. “Markets today are much more transparent, so for our businesses, having the angle and figuring out how to execute a business plan has become critical.”
Other markets where those angles are being pushed, according to our participants, are Boston and Silicon Valley, both areas affected by the tech downturn. Silicon Valley, in particular, given its size and long-term viability as a technology center, stood out as one of the most attractive office markets for opportunity fund investors, especially since it has only been very recently that any signs of life have begun to re-emerge in the office sector.
As but one example, earlier this year, a Praediumjoint venture purchased a 227,000 square foot business park in Santa Clara, California for approximately $26 million – six years earlier, the property had traded for almost $10 million more.
Unlike Florida, where many high-yield investors are looking for focused opportunistic situations in a demographically strong market, Silicon Valley provides a more traditional approach: profiting from distress. Although funds are scouring the Valley looking for office investments, the primary issue, according to Blackstone's Cohen, is how long it will take for the market to turn the corner: “The big question for value-added investors in Silicon Valley and Boston is this: we believe that rents are ultimately going to go up, but if it takes five or six years instead of two, that is a very different investment.”
As Jacobsson added, “If you have to wait five years to put your strategy in place, you're not going to make a lot of money for your fund.”
The question was posed if there were any other markets outside of the ones already mentioned that the panel found attractive. “If you had ten of us here instead of four, you'd have the same answers,” Cohen said, referring to South Florida, Silicon Valley and Boston. “That said, we actually bought a building in Pittsburgh earlier this year. Of course, we're not going to do that often, but if there's an opportunity, we'll go anywhere.”
Although our participants are willing to invest anywhere given the appropriate circumstances – Apollo also has a substantial office property in Pittsburgh, for example – one of the strategies they have not been pursuing is groundup office development. Although breaking new ground for residential buildings is attractive in certain markets, the group pointed out that office development involves much greater risk due to the uncertainty of demand when the building eventually comes on-line.
“From our standpoint, we know markets are improving today,” said Appel. “If you start a new office building, you're not going to be leasing it for two or three years. We're buying vacancy, we're buying things that we can improve, but what we're not doing is developing ground up.”
Franco agreed, noting that office development is “a tough business to make money in.” He referenced the multiple factors that one needs to get right – from construction costs to timing in addition to the basic fundamentals of simply leasing up the space – in order to hit opportunity fundlike returns. “We've developed office and had some great success – One Lincoln Plaza, for example,” he said, referring to a Boston office tower that Morgan Stanley and its partner, Gale Co., sold last year for more than $700 million. “But if we missed that by four months, we're sitting on a vacant building.”
Even Jacobsson noted that Apollo was reticent to engage in office development deals, notwithstanding their involvement in the Time Warner Center, one of the biggest ground-up developments in New York City history.
“The Time Warner Center had a very substantial office component,” he noted. “But before day one, the space was already accounted for because Time Warner was going to buy 90 percent of it. Even in the late nineties, when things were recovering nicely and there hadn't been a lot of new product in Manhattan, we still didn't want to take the risk on one million square feet of office.”
All in all, despite the difficulties inherent in being an opportunistic investor in today's market, the participants agreed that, relative to last year, the office sector was drawing more of their interest. Although some of our participants couldn't say with as much certainty as Morgan Stanley's Franco that they would be a net buyer of office properties over the coming twelve months – Morgan Stanleyhaving sold off a significant piece of their office holdings recently – they all echoed his sentiments.
“Our interest and activity [in the office sector] has been higher recently,” he said. “And over the next year or two, we expect that to continue to be the case. We view office as increasingly attractive in the US.”
How that scenario plays out over the next 12 to 24 months will depend on a variety of factors – our participants noted they're keeping their eye on employment growth, the long-end of the interest rate curve and new supply – but it seemed safe to say, sitting in that room, that the office market will become increasingly important for opportunity funds in the coming months and years ahead.
Of course, when it comes to private equity real estate firms – particularly in today's dynamic real estate market – it's best not to draw too many hard and fast conclusions.
“Things do change over time,” Jacobsson said. “It's a natural course of all of our businesses. If you did the same thing year in and year out, you wouldn't be opportunistic. You'd be violating the fundamental principle of the whole industry.”
President The Praedium Group
Appel is president and co-founder of The Praedium Group, a boutique private equity real estate firm that primarily focuses on middle market US assets, each generally less than $75 million. As a company, Praedium began at Credit Suisse First Boston in 1991, becoming independent five years ago. The firm's most recent fund, Praedium Fund V, closed on $465 million in 2001 and has invested approximately 19 percent of its capital in the office sector. “We really focus on assets that are underperforming their peers in the marketplace,” says Appel. “By putting a business plan in place that will take that asset from an under-performing level up to market conditions, we seek to generate higher returns without necessarily higher risk.”
Managing Director The Blackstone Group
Cohen joined The Blackstone Group in 1996, where he has been involved in approximately $3 billion of real estate acquisitions encompassing all property types across the US. The firm's real estate business is focused on opportunistic investing through two primary funds: Blackstone Real Estate Partners IV, the firm's US-focused vehicle, which closed on $2.2 billion in 2003 and Blackstone Real Estate Partners International, a European-focused fund, which closed on €800 million in 2002. “First and foremost, our strategy has been to focus on larger transactions,” says Cohen. “Historically, we've bought a third office, a third hotels and a third other types of assets. We have a very broad mandate, but I think we've tried to stick to those core values.”
Managing Director Morgan Stanley
Franco, a 15-year veteran of Morgan Stanley, is the head of Morgan Stanley Real Estate Funds (MSREF) in the US. Having been involved exclusively with the firm's real estate group since joining Morgan Stanley in 1990, he is now responsible for setting MSREF's US strategy and sourcing and executing US investment opportunities. Today, Morgan Stanley owns approximately $40 billion of real estate assets worldwide across a number of different funds and strategies. MSREF IV, the firm's most recent opportunistic vehicle, closed on just over $2 billion in 2001. “Formerly, we've just been an opportunistic investor,” says Franco. “But over the past five years, our focus has been to expand our business, not just globally, but also across product types.”
Managing Partner Apollo Real Estate Advisors
Jacobsson has been with Apollo Real Estate Advisors since its founding in 1993 and is a managing partner responsible for new investments and investment management. Over the past twelve years, the firm has overseen the investment of eight real estate funds, including five US vehicles, two European funds and a mezzanine debt fund, as well as two joint ventures, through which it has invested over $4.7 billion. “One of the reasons we've gotten into a variety of business lines is the evolution of the market,” says Jacobsson. “It was our desire to take advantage of a lot more types of deals that we would otherwise be unable to do.”