The office investment market is back on track and buoyed by significant sources of capital for deal-making, following some political and economic uncertainty over the past year, according to a mid-year Office Investor Sentiment Report by Real Capital Markets (RCM). Investors are starting to look more closely at the investment value of co-working space, however, given its rapid expansion and potential exposure to any market downturn.

“Conventional wisdom and years of experience tell us that we may be long in the cycle,” says Tina Lichens, COO of Real Capital Markets. “At the same time, there is a broad sense of optimism, albeit somewhat cautious, that with the level of capital poised for investment, there are still allocations to be met and transactions to be completed.”

Key trends impacting the office investment market, according to the report, include:

• Investors are cautiously confident—Economic expansion, population growth and low unemployment all bode well for the sector. However, there is caution given the length of the cycle, and concern about how a downturn would impact pricing.

• Coworking expansion continues but concerns about saturation emerge—Some investors expressed concerns about coworking market saturation and how it might impact property values in the event of a downturn.

• Suburban office investment is seeing a resurgence—Select suburban markets with strong job and population growth are experiencing increased activity, which includes value-add transactions.

• Top operational issue is increase cost of tenant improvement—TI costs are rising considerably faster than rents, an issue across the country and especially in markets with lower rents.

Expecting Consistency

Investors interviewed and surveyed by RCM suggest that the U.S. office investment market is back on track, following a slow down at the end of 2018 that lingered into early 2019. Political and economic forces—the government shutdown, uncertainty about interest rates and the real threat of tariffs and trade war escalation—raised questions, generated considerable uncertainty and slowed activity.

However, at the mid-point of 2019, property owners, investors, and brokers expressed confidence in the health of the market given the strength of the economy, continued job growth and population expansion in many markets. This is reinforced by the estimated $200 billion in dry powder allocated to the commercial real estate market.

Coworking Creates Opportunities & Risks; Is Saturation Near?

One of the most significant storylines from the report is the ongoing expansion in coworking, which accounted for nearly half of the U.S. office absorption in 2018, according to industry experts. Given this rapid expansion and its impact on building vacancy rates across the country, some investors are questioning whether this market segment is nearing a saturation point. And, from an investment standpoint, how much is too much?

Experts noted the top three ways coworking is impacting the market: pushing vacancies down, creating an incubator mindset, and paving the way for more dramatic disruption to office leasing.

Well Located Suburban and Emerging Markets Top Opportunity List

RCM survey participants noted that value-add suburban properties offer the greatest opportunities in today’s office market, along with well-located properties in emerging markets. Each of those market segments were noted by more than 37 percent of respondents. Markets with good fundamentals, including population and job growth, as well as a highly trained labor force, are making the grade with investors. Those include Charlotte, Chicago, Kansas City, Minneapolis, Phoenix and St. Louis, among others.

On the other end of the spectrum, the three property categories seen as less attractive, or having the least opportunity, are stabilized, well-located downtown buildings, trophy properties and stabilized, well-located suburban properties. These findings reflect the perceived lateness in this investment cycle and investors continued focus on growth, value and yield.

Operational challenges are impacting value

In spite of its relative strength and consistency, the office sector is not without its share of challenges. In rank order the biggest challenges are the cost of tenant improvement allowances, the ongoing trend of tenants taking less space and the cost of converting underperforming assets.

Tenant improvements are a great underwriting challenge. Universally, tenant improvement costs are increasing considerably faster than rents. Increases in tenant improvements make it problematic, especially in markets with lower rents. While there can be greater disparity in rental rates from primary to secondary and tertiary markets, tenant improvement costs, from materials to labor, are more consistent, regardless of geography.

“We’ve reached a very interesting time in this current investment cycle,” says Steve Shanahan, Executive Managing Director, Real Capital Markets. “This is an investment cycle that despite its challenges, has been extended by robust levels of capital available for investment coupled with putting many lessons that have been learned from past cycles into practice.”