By Meghan Hall
Gateway markets around the country, from established cities such as San Francisco to emerging hubs like Seattle, have seen their commercial office markets thrive, with pricing for top-tier product rising and producing rising total turns for investors. And, thanks to strong local economies, vibrant talent pools and stable leasing metrics, investor demand for office assets in these gateway markets will continue, according to Newmark Knight Frank’s Gateway Office Capital Markets Report.
“What gateway markets provide, while they might not see the highest gross return and investment volume might be off-peak, they provide long-term diversified portfolios. The underlying value of property in a gateway market is extremely strong,” explained Newmark Knight Frank Capital Markets Research Analyst Daniel Littman. “Top-tier employers, robust and diverse economies: These are the things that help support value in these markets.”
The safety, stability and value that commercial real estate provides for investors — especially ten years into the current market cycle — provides a sort of safe haven, Littman explained, one that contributes to commercial real estate’s strength as an asset class. Nationally, major gateway markets saw their overall investment sales volume growth increase by 4.5 percent year-over-year at the end of 2018, increasing to $74 billion in office volume, up from $71 billion in 2017. Overall, U.S. office volume also ticked upward, although the change was less significant, recording a 1.2 percent increase and $61 billion of investment at the end of the year.
While 2018 levels of investment were still a decrease from peak levels reached in 2015, demand for top tier and core office assets is expected to continue due to the stability that gateway markets provide.
“Last year we had an increase in investment sales, and when you look at leasing metrics, those also have strong years,” said Jonathan Mazur, senior managing director of national research at Newmark Knight Frank. “It can be year one or year ten in a cycle, but in this case, it happens to be year ten. The underlying fundamentals of the markets are really strong; employment is headed in the right direction and the office market is very competitive. I don’t think we’re ready to project the next downturn.”
In 2018, every metro gateway market — including San Francisco and Seattle — recorded a greater number of trophy deals than their historical average. Seattle managed 15 deals greater than $100 million in 2018, compared with its historical average of nine, while San Francisco managed 37, compared with its average of 29, states the report. Both metros also saw the largest increase in total returns over the course of the last year, with San Francisco’s returns increase to 10.8 percent due to limited available product and high levels of demand. Seattle also achieved total returns of 10.6 percent thanks to price appreciation and institutionalization of the city’s office market.
While office sales volume in San Francisco’s central business district decreased by 10 percent over 2018, this, Newmark Knight Frank states, is more of a function of a lack of available product on the market and is not a reflection of the metro’s leasing fundamentals. Properties within the city are trading for about $917 per square foot, an increase of 7.9 percent year-over-year and well above the historical average of $500 per square foot. The largest transaction of the year was Northwestern Mutual’s purchase of Embarcadero Center West and 275 Battery St. from Rockpoint Group for $412.5 million.
On the leasing side, rental rates in San Francisco increased by nearly 14 percent year-over-year, representing the strongest growth of any city in evaluated by the gateway markets report. Tenants continue to drive demand for Class A product despite a lack of available space, keeping the office vacancy rate around 5.8 percent and rental rates around $70.48 per square foot.
“Bay Area fundamentals continue to trend upwards and the capital markets are not far behind,” stated Newmark Knight Frank’s Vice Chairman Steven Golubchik in the report. “We continue to see new capital moving into the market and a growing focus on urbanized markets with transit and amenities.”
2018 was also one of Seattle’s best years for investment sales volume this cycle, as the city reached $5.2 billion in investment by both domestic and international groups. Downtown Seattle saw a record level of development, with just under 6 million square feet of space currently under construction. This, states, Newmark Knight Frank, could increase greater amounts of institutional investment. Currently, office property is going for around $426 per square foot and pricing remains at peak levels. The largest transaction of 2018 was CBRE Global Investors’ sale of Metropolitan Park East & West, 1730 Minor Ave. and 1100 Olive Way to Beacon and CalSTRS for a combined $435 million. In another large transaction, Unico and AEW Capital bought 111 Third Ave. from Callahan and Ivanhoe Cambridge for $359 million.
Leasing fundamentals continued to strengthen as the office leasing market has recorded 25 quarters of positive absorption and a 6.5 percent year-over-year rental rate increase as vacancy dropped 100 basis points to 9.4 percent, states the report.
“The Puget Sound office market is one of the leading gateway markets in the U.S. and offers ample liquidity as it is a target market for nearly all institutional capital, both foreign and domestic,” said Newmark Knight Frank’s Vice Chairman Nick Kucha and Co-Head of U.S. Capital Markets Kevin Shannon. “Amazon and Microsoft have put the region on the map as a hotbed for tech, attracting other tech giants, such as Google and Facebook, who have collectively dominated leasing activity in Seattle and on the Eastside.”
This growth, said Littman, has been revolutionary for commercial real estate over the last market cycle as investors have learned from the Great Recession and gateway markets, with their variety office asset classes, provide ample opportunity for growth.
“Just in the general expansion of the alternatives investments this cycle, we have really seen it in real estate. Capital is going places this cycle it didn’t go last cycle, like specialty asset classes such as medical offices, student housing,” explained Littman. “All of these investment types are coming into their own and falling into the wider commercial real estate bucket. We’re really talking about a shift in the DNA of this cycle compared to last cycle.”
