Commercial Investment Real Estate March/April 2019 | Page 28

Investment strategies run the full spectrum, with capital available for more stable core and core-plus assets to riskier value-add and opportunistic properties in both urban and suburban markets. Some investors, however, are tweaking acquisition criteria to account for slowing growth. The office market has struggled with a tepid post-recession recovery over the past several years and is bracing for a further slow- down. Office vacancies are expected to tick slightly higher to 13.2 percent in 2019 and 13.6 percent in 2020, accord- ing to the ULI Fall 2018 Real Estate and Economic Fore- cast, while rent growth will slow to 2 percent this year and 1 percent in 2020. Middleton Partners is one investment group that is adopting a more conservative strategy to fit changing market conditions. “As the market cycle has matured, we have become focused less on lease rollover risk and more on predictable income stream,” says Mark Cypert, CCIM, a partner at Middleton Partners, a Chicago-based private equity investment group. The firm has shifted from value- add investing several years ago to focusing on acquiring INVESTORS TACKLE NEW UNDERWRITING CHALLENGES Investors are acquiring office assets even as they face a flurry of challenges forcing them to sharpen their underwriting skills, such as soaring construction costs, disruptive technologies, and expansion of coworking. Explosive growth in coworking and flexible workspace is front and center for office investors. For the past three years, the U.S. has added more than 5 million square feet of coworking space annually, according to Cushman & Wakefield. The firm estimates that the flexible space market currently represents 1 percent of the total multitenant market, with the potential to grow to between 5 and 10 percent in the future. “I believe the coworking trend will be transformative for the office market,” says Rebecca Wells, CCIM, senior vice president of investment sales at Lee & Associates in Indianapolis. The metro area is home to 14 different coworking providers that are leasing space, or in the case of Novel Coworking, purchasing their own buildings. The office is where people spend most of their time, and people want to make that part of their day more interactive. Coworking also allows for greater flexibility on the part of the tenants who might be unsure of their expansion or contraction needs in the short term. Nationally, landlords and real estate service firms also are moving into coworking. Brookfield and RXR Realty have partnered with Convene to design and service flexible workspace at properties, with initial projects up and running in Los Angeles and New York City. CBRE also launched its own flexible workspace subsidiary, Hana, in early 2019 to provide flexible workspace consulting services to both landlords and tenants. “Coworking and flexible space is clearly a trend that we see continuing going forward,” says Mark Cypert, CCIM, a partner at Chicago-based Middleton Partners, a private equity investment group. Investors are keeping that trend in mind with an aim to build out spaces that are coworking- 26 March | April 2019 friendly with open, flexible floor plans and building ameni- ties that will help to attract tenants — whether that is employers or coworking space providers. In addition, the general trend is to pack in more people per square foot, which affects everything from parking density and floor plans to capacity for elevators and restrooms. “When we do forecasting for future demand, we take those funda- mental changes into account,” Cypert says. Upgrading Class B Properties Another challenge for investors is the transformation occurring within the Class B office market. Some Class B property owners are spending more money to attract big tenants, which in some cases, is resulting in retrofitted B buildings that are on par with some Class A towers, says Paul Waters, CCIM, chief operations officer at Integra Realty Resources in New York City. High-profile examples of that include General Electric in Boston and Google and Amazon in New York City. Those upgrades are creating new underwriting challenges for investors looking to buy those upgraded Class B assets. “The variance between some A Class and B Class space is really making investors sharpen their pencils quite a bit,” he says. For example, is a Class B retrofitted building in Manhattan now a better return on investment than a Class A tower? It might be, and that certainly wasn’t the case 10 years ago, Waters says. In addition, investors buying Class B buildings are, in some cases, looking at spending the same money on fit-out of tenant spaces that is more typical of a Class A building. Investors must carefully analyze whether they can achieve the rents necessary to justify those higher investments in building improvements — especially amid soaring construction costs. “It is very challenging for some investors because the increased fit-up dollars are changing the profile of everything,” Waters says. COMMERCIAL INVESTMENT REAL ESTATE