Office Market Update
The Office Update:
The Dallas–Fort Worth office market ended with a 4th quarter 2009 vacancy rate of 17.3% decreasing from the prior quarter. DFW had a positive absorption of 350,371 net square feet during the fourth quarter as compared to 66,579 square feet of absoprtion in the third quarter of 2009. Class B Office Space absorbed 583,841 square feet and led market absoprtion by product type and is compared to (52,481) square feet absoprtion of Class A Office Space and (180,980) square feet of Class C Office Space.
New office building developments in Dallas Fort Worth area in this 4th quarter of 2009 represented 25 buildings and 309,936 square feet and is compared to the prior quarter deliveries of 32 buildings aggregating to 1,399,977 square feet. Office Cap Rates actually decreased in 2009 from 8.66% in 2008 to 8.21% when comparing the same period in the prior year according to Costar making the long-term outlook much brighter compared to the value erosion in the national markets.
A graphic chart of historical cap rates of transactions over $5,000,000 as computed by Real Capital Analytics is depicted below:
The minimal amount of new product currently in the pipeline will alleviate vacancy pressure. Sublease inventory increased from 2,549,368 square feet from 2,313,687 square feet in the third quarter of 2009. This has allowed stronger tenants to gain a pricing-power advantage in the “landlord-tenant” negotiation. We anticipate a “flight-to-quality” as stable tenants upgrade their space accommodations into higher quality assets moving from the Class C to B sector.
Through the first three quarters of 2009 total sales activites in Dallas Fort Worth included 14 office sales transactions aggregating to $33,690,000 of sales volume at an average price of $56.24 per square foot . This compares to sales activity through 2008 which represented a total of 50 transactions on a sales volume of $1,085,366.254 at $146.38 per square foot according to Costar.
However, tenants are cautiously reaping the benefits of the buyers market and being careful not to make any new leases with a property which has weak ownership. Property owners are also searching for tenants that can maintain cash flow integrity with a solid ability to weather the recession.
This market should open new opportunities and trigger increased occupancy in the office-flex sectors for tenants looking to find price significant savings that would not be typically available in the full-service office sector. We also anticipate increased demand for higher density office utilization, which will allow offices with higher parking capacities to take a disproportionate market share of potential lease prospects, while companies work on managing their bottom lines.
We fully expect office tenants to remain in a lateral position for 2010. We are starting to see increase corporate earnings which will ultimately drive offfice occupancies upward with meaningful expansions. Larger 10-year term deals will become rare as corporate America becomes less willing to make long-term financial commitments. Many tenants are questioning the timing of the real market bottom creation at which time they will start to extend their lease terms. However, Dallas-Fort Worth continues to attract corporations who restructure and transfer headquarters to the vibrant and price competitive marketplace as evidenced in the recent relocation of Comerica and AT&T to the Dallas Metroplex.
The Dallas-Fort Worth office sector is not experiencing the massive occupancy degradation that the recession is imposing upon most of the country. Although not as plentiful in years past, there will be opportunities to make profitable real estate decisions. Dallas poses a solid play for property owners wishing to leave markets who have been hit been hit hard by the recession.
Caution Flags are surfacing with "Blood-in-the-Water" Investors on the Prowl:
Businesses continue to cautiously weigh their decisions with increased levels of scrutiny. These deal dynamics will require working with sophisticated professionals who can produce accurate deal prognostics, and fine-tune a winning “risk-reward balance” on potential investment opportunities.
The lack of credit has dramatically impeded business operations. Banks will continue to hold their capital until a level of foundational assurance is realized. Many institutional investors are seeking high-level bond yields which approximate 15% per annum returns. This makes the feasibility of investment in commercial real estate less compelling as investors seek to procure reasonable debt capital for their real property investments.
While banks in the Dallas-Fort Worth market are approving deals, the requisite equity component has become a major hurdle for traditional developers. The traditional 70%-30% debt to equity ratio has severely deteriorated and is more reflective of a 55%-45% structure. Increased capital raising by REITS has allowed this market purchaer to become more active in the maketplace.
Transactions that are being completed are often comprised of assumable debt, seller financing, or stable long-term leases which provide the economic stability to mitigate risk for the institutional investor. Larger deals such as portfolio transactions are much harder to transact than in the prior year, and this trend is anticipated to continue as mortgagees prefer to spread their risk than have a consolidation to a specific borrower or asset.
Local banks are decisively holding onto “lines of credit” and the unforeseen challenge will be to convince businesses to be aggressive to take advantage of market conditions. Real estate is no longer the preferred “asset of choice,” as cash has loudly declared why it is still “king.” The ability to accumulate capital will give cash-strapped investors the ability to weather the current market volatilities and sail to new levels of perceptible opportunities in late 2010 or 2011.
Both corporate and consumer confidence and corporate profits are going to be the rudder which will ultimately determine the long-awaited return to consumption. The economic policy of the Obama Administration has been substantially impeding business growth and has put a lot of uncertaininty into today's executive decison makers and Wall-Street Investors. This governmental power assetion and substnative nationalization of various industries including banking, auto-manufacturing, insurance, and health care is become very problematic for the traditional business owner. The minimal impact of governmental stimulus and TARP funds is being questioned in the marketplace. Determining what will spawn meaningful economic growth in the United States will have an impact on all markets including Dallas-Fort Worth. The current trends would indicate that until the influx of bad loans finally leaves the market place, banks (the ones remaining) will keep a tight purse on their capital base.
However, banks are trying to work through troubled real estate by resolving the asset disposition by selling notes rather than pulling the foreclosure ripcord. Their continued adoption of the "pretend and extend" management policy of trying to work with borrower's who can continue to debt service their properties is delaying resolution of many of today's troubled assets within the real estate community. They are trying to protect their own capital base undesirous of having to recapitalize their own capital base which would be required if they were to bring in troubled assets back into the bank as a non-performing loans through the foreclosure process.
Numerous Investors have been looking for the “blood in the water” deal opportunities. However, many of them have been frustrated to date as there has not yet been the previously anticipated velocity of "stress-ridden" sales to fill the voracious appetites of bottom-feeder investors. Some of these investors have been pursuing potential note acquisitions embracing that “loan-to-own mentality” that once permeated our marketplace in previous cycles.
A synopsis of the Office Sales and Lease and Price Inventory in DFW is set forth below:
Office Property Sales ('09 Yr. End) 14 Bldgs. $33,690,000 Vol. - 97%
Class Buildings Inventory SF Rate/SF Vacancy
[A] 431 117,940,934 $22.90 18.5% [B] 4,143 160,170,470 $18.30 18.3% [C] 4,184 44,736,943 $14.73 10.9%
Total Office 8,758 322,847,947 $19.95 17.3%
5 Yr. Office Employment Growth: 4.20%
Inventory Growth: 7.10%
Difference: - 2.90%
2009 1st Quarter Net Absorption 547,891
2009 2nd Quarter Absorption (507,096)
Cap Rate Breakdowns Quarter 2008 2009
Average Cap Rate 4-08 & 1-09 8.21% 8.66%
Average Sales Price / SF 4-08 & 1-09 $146.38 $56.24
Office Property Sales ('09 Qtr. 1) 7 Bldgs. $51,540,000 Vol. -47%
Class Buildings Inventory SF Rate/SF Vacancy
[A] 431 116,685,705 $23.35 17.6% [B] 3,891 154,809,632 $18.46 18.2% [C] 4,001 42,794,753 $15.29 10.1%
Total Office 8,323 314,209,090 $20.19 16.9%
5 Yr. Office Employment Growth: 10.10%
Inventory Growth: 6.40%
Difference: 3.70%
2009 1st Quarter Net Absorption 547,891
2009 2nd Quarter Absorption (507,096)
Cap Rate Breakdowns Quarter 2008 2009
Average Cap Rate 4-08 & 1-09 8.21% 9.20%
Average Sales Price / SF 4-08 & 1-09 $98.07 $101.80
Cap Rate Explosion = Value Erosion
Second half 2008 Cap Rates were not fully reflective of the current marketplace where cap rates are approaching 10% as the market was in major transition. Why is this occurring?
Wall Street’s CMBS pipeline filtered massive long-term debt into the commercial real estate market resulting in significant cap rate compression and asset value appreciation. In today’s current market place long term debt is very scarce, and CBMS financing nearly non-existent. Needs for increasing equity and capital liquidity are growing, triggering a cap rate explosion.
Substantive property value erosion is now occurring . Decisive action is becoming increasingly important. Owners must now contemplate the merit of jumping out ahead of a “falling knife” and transacting a property sale or evaluate the “risk-reward” dynamics of holding onto the asset through the next investment cycle. The following graphic depicts this cap rate explosion phenomenon:
Historic Distribution of Cap Rates From 2002 Through 2008
Cap Rate/Year 2008 2007 2006 2005 2004 2003 2002
5% or Less 13.4% 18.28% 15.04% 14.94% 6.03% 1.99% 0.87%
6% or 7% 57.99% 63.39% 61.42% 52.91% 43.18% 27.87% 11.49%
8% or 9% 24.86% 16.47% 20.92% 27.69% 40.94% 52.88% 53.28%
10% or more 3.75% 1.86% 2.62% 4.46% 9.85% 17.27% 34.35%
Data Source: Real Capital Analytics
The New Rules of Money - Rebalancing the Equity Equation
Investors are being forced to reevaluate the asset holding cost of their portfolio assets. With cap rates exploding and property values eroding, the adjusted requisite equity contribution to secure new financing is staggering. The above example contemplates an original $20,000,000 asset and a $4,000,000 equity position.
As the loan underwriters require a 65% loan to value structure, the additional equity requirement is pictured as the cap rates increase at 100 Basis Point Increases from 6.5%-9.5%. The Original Equity of $4,000,000 requires an additional capital requirement of $7,894,737 if cap rates increase to 9.5%.
More importantly the asset value decreases from its orignal $20,000,000 to $11,578,947. All investors who have refinancing requirements in the next five to seven years must evaluate whether or not such additional capital injections are appropriate as they try to optimize their portfolio holdings.
