Investors project spikes in office building rents.

Real estate is riding high with investors as they try to buy property now, before prices rise any higher. Office buildings are perceived to be a particularly good investment because prices of existing buildings are low compared with the cost of constructing a similar new building today.

The millions of square feet of vacant office space nationwide is filling up, and rents are going up slightly in some markets and significantly in others. As a result, office investors are projecting rent spikes in many metropolitan areas. These are among the findings of a recent survey of institutional real estate investors, published in the Korpacz Real Estate Investor Survey.

"More than halt of our survey participants are factoring spikes into their analyses of some potential acquisitions in strong markets or those that are on the verge of improvement," said Peter F. Korpacz, MAI, publisher of the survey. "Typically, investors will project initial rent increases at about the general inflation rate, but a rent spike is markedly higher. For example, if inflation is 3.5 percent, one might expect a spike to be approximately 50 percent to 100 percent higher than the inflation rate - say, 5 percent to 7 percent."

The respondents to the Korpacz Survey who use rent spikes say they are extremely cautious in doing so, and they maintain that spikes are heavily dependent on local conditions. Often they are appropriate only on a specific property. Spikes are used where the amount of vacant space is declining and rents are beginning to rise or where there is hard evidence that this will happen relatively soon. "This includes a diversified economic base, job growth, good current absorption of vacant space, and a strong indication of higher rents," said Korpacz.

Upside Potential Prompts Rent Spikes

Showing the renewed confidence investors have in downtown office markets, 83.3 percent of the respondents who invest in CBDs across the nation project rent spikes. This compares with 69.2 percent one year ago. More than two-thirds (76.5 percent) of the respondents also project spikes in suburban office markets, compared with 68.8 percent one year ago. "The disparity is most likely due to the fact that, in general, suburban office rents have already increased faster and higher than rents in CBDS," said Korpacz. "Consequently, there is less room for future increases."

The rent differential between suburban and downtown buildings is a significant factor in the decision to buy in a CBD. Many CBD leases were signed during the recession, when landlords were eager to negotiate with tenants to keep occupancy at a tenable level. In many cases those rents are below current market rent.

Investors are willing to pay up-front for properties in which there is opportunity for rent increases in the near term. "The question they ask in the current office market is: 'What can I average in the first five years?'" Korpacz said. Many investors are willing to take some leasing risk if they are confident in the long-term potential of the property and the viability of the downtown market.

Current reported spike amounts are as high as 20 percent, but most fall into the 8 percent to 12 percent range. The 20 percent, top-of-the-range spikes are in the national CBD office market and the Manhattan office market.

Spikes are most often projected over several years. "It would not be uncommon to see three years of 8 percent bumps," reports Korpacz, "but an unusually high spike may be applied for one year only."

Many participants time their projected spikes according to anticipated supply-demand balance. Others use spikes in the early years following an acquisition, especially in markets where conditions are already improving.