When many think of investment into the office sector, they
think of the core assets that define skylines and can serve as
marquee assets in a portfolio. These assets represent the flight
to quality that has undergirded much of the liquidity we have
seen in the office sector over the past several years.
But with the US economy in the second-longest expansion
cycle on record, some
investors are focusing less
on those core assets—the
ones that would likely
hold their values the best
in the case of an economic slowdown. Instead,
they are choosing to focus
on value-add urban office
assets. This is the sector
where liquidity is highest.
While it may seem
counterintuitive to buildings that might be riskier,
there are several factors
driving these value-add
A concentrated hunt for yield and willingness to look outside of primary markets are factors contributing to a rise in
investor interest in the value-add office space. And fundraising
continues to favor higher-returning strategies.
Over the past four quarters, rents have risen by 2.8%, which
is consistent with the annual gains seen in recent quarters. But
for class A space, year-over-year growth has been slower, at just
1%. Many of the nation’s CBDs are reaching an inflection
point where new supply is being delivered while second-gener-ation blocks are also hitting the market.
At the same time, core cap rates continue to range from 4%
to 5% in many primary gateway CBD markets for these assets.
These barriers have made many investors look outside of core
product to value-add urban offices.
While initial yields on value-add office investments may be
thinner than core product, as they require some effort and
capital to achieve stabilization, we often see value-add office
yield on cost build to at least a 150- to 200-basis-point premium
on core product.
Value-add investors are also looking to take advantage of
current pricing and are cautious about the potential for the
market to soften. This is leading some investors to compress
their hold horizon. Where it was once standard to build value
and sell on a five-year plan, three years is increasingly becoming the new norm.
As a reflection of this strategy’s popularity, we have seen
fundraising for value-add investment significantly increase.
Value-add funds continue to be very active in the markets, with
more than $14 billion raised in the first half of this year,
accounting for nearly 44% of fundraising. These vehicles are
also getting more focused, as opposed to being more diversified in recent years.
This development is pushing dry powder to historically high
levels, to an aggregate of $178 billion as of midyear 2018. This
vast accumulation of dry powder highlights the challenges that
managers are facing to deploy capital. As a result, the imbalance between supply and demand in the real estate capital
markets continues unabated.
The search for those opportunities has more frequently
pointed investors toward secondary markets supported by
strong fundamentals. Strength in secondary markets continues
to be a significant driver of investment activity. In the first half
of 2018, the top three markets in terms of year-over-year
growth in office transactions were Minneapolis, Raleigh-Durham, NC and Nashville. These markets have excellent
labor pools and fast-growing populations, making them a
prime target for investors looking to gain a foothold there.
There is no sign of a softening in investment demand for
value-add office buildings. As pricing for core product remains
elevated and yields remain steady, this value-add strategy will
continue to attract capital. ◆
Though Cautious, Capital
Is Still Chasing Value-Add
With more than
$14 billion raised in
the first half, value-add
funds account for nearly
44% of fundraising.
BY NOOSHIN FELSENTHAL
Nooshin Felsenthal is a managing director with JLL in Chicago. She may
be contacted at firstname.lastname@example.org. The views expressed
here are the author’s own and not those of the ALM Real Estate Media
Group or its publications.