Well-Leased Properties Losing Appeal?

With the economy threatening to slip back into recession, many commercial real-estate investors believe the best way to weather the storm is to stick with well-leased buildings in major markets.

But a new study from CoStar, a commercial-property-analytics company, suggests that the conventional wisdom has it wrong this time. The study found that leases in a number of buildings in New York, San Francisco and other hot markets are set to expire next year, when weak economic growth could prompt tenants to demand significantly lower rents to renew leases.

The big markets tend to spring back fastest from economic downturns and are first to see stronger job creation when the economy begins growing again. That puts upward pressure on rents, especially in supply-constrained cites like New York and Washington.

“In a double-dip, everything is less desirable,” says Marc Halle, managing director of global real-estate securities for Prudential Real Estate Investors. “But I’m going to want bigger markets with more depth and capital demand,” Mr. Halle says, echoing a widely held view.

CoStar argues that a disconnect between the rising prices paid for buildings and the current rents they can demand ought to make investors pause.

In Manhattan, for instance, the company found that, despite recent gains, office rents are still nearly 28% below their peak prices in 2008.

In Los Angeles and San Francisco, rents hover around 15% below their 2008 peaks.

Washington, where stimulus money and private jobs created around the government kept rents flat, is the notable exception.

Many leases during the previous cycle were signed between the second quarter of 2007 and second quarter of 2008. Nationwide, most rental agreements also were short-term in nature. In San Francisco, for example, about two-thirds of leases signed during that period were of five years or less, CoStar says. That means many contracts signed then will begin rolling off next year.

“Investors have to be careful about the lease vintages when buying buildings in these cities,” says Chris Macke, a CoStar strategist. “In places where many rent contracts were signed well above current market prices, landlords will have a hard time finding tenants who will pay anything close to that rate.”

In Houston and Philadelphia, by contrast, rents are only about 5% below their peaks. When short-term leases expire there, landlords have a better chance of finding tenants willing to pay prices near the height of the market, Mr. Macke says, with no appreciable drop in income.

Not everyone is convinced. Matt Bronfman, chief operating officer for Jamestown Properties in Atlanta, says that rents in second-tier cities like Houston and Atlanta didn’t fall as much because they never rose much in the first place: Over periods of 10 to 20 years, he says, those lease prices tend to move within a narrow band.

“I want to invest in cities with barriers to new supply and a consistent flow of white-collar jobs to see long-term rent growth,” Mr. Bronfman says. “That means we have a bias toward the major markets.” (credit c, karmin, wsj)

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