Why office properties and which ones? Part 1

John Greenman

Letter from Denver

Within the world of commercial real estate investing, office properties can be a controversial investment choice. Critics say that office buildings are more capital-intensive and more volatile in their returns than the other major property types—namely, multi-family, industrial, and retail. (Here we leave aside the hotel sector as in reality a hotel is a complex daily operating business housed inside a real estate shell rather than a traditional real estate asset with longer term leases). So why take the risk of owning office properties?

In Part 1 of this blog entry, we focus on institutional investors; in Part 2, on private investors.

Correct allocation

First of all, institutional investors seeking to be properly allocated to the commercial real estate (CRE) asset class will need a sizeable exposure to office property. After all, office buildings make up 50% of existing stock of CRE as measured by investment value.

Dynamic valuations

Second, “market-timer” opportunistic funds and other institutional investors driven more by total return (IRR) criteria than current income buy office buildings because like the fact that the office sector can move upward in value more quickly that other property types when a particular sub-segment within the overall demand for office space increases rapidly owing to changes in the overall economy.

We saw this Houston during the oil and gas boom of 2012–2014, and we’re seeing it in the explosive high-tech expansion in the San Francisco Bay area that began in about 2010 and is still going strong—office rents in San Francisco have doubled since 2010.

Prestige and happiness

A third factor for some investors, particularly sovereign foreign funds and some very high net worth individuals, can be the prestige and enjoyment derived from owning an iconic office property. It’s simply more fun to own Rockefeller Center or the TransAmerica Pyramid in San Francisco than even the world’s nicest warehouse.

What about high net worth individuals?

But what about the private investor who just wants a good risk-adjusted return when diversifying his overall portfolio to include commercial real estate? Office can still make sense for such an investor, but only a certain kind of office. Precisely what kind is our focus in Part 2.