Opportunistic commercial real estate investors discouraged by the region’s lack of supply of core assets could begin scooping up previously untouchable buildings with some vacancy in less desirable locations before prices of commercial real estate increase with an improving economy.

Pension funds and other institutional players are set to dominate the local commercial property investment sales market – as long as stabilized assets are for sale in prime locations.

But once those deep institutional pockets purchase the prime properties, that could afford others a chance to focus on less glamorous, value-add portfolios.

While the commercial real estate market in Massachusetts did not necessarily thrive in the last three years, it also has not been crippled by the vacancy rates experienced in other parts of the country, so many core properties have been able to maintain tenant rosters and rental rates.

It is precisely those properties that pension fund managers and foreign investors are hunting for. And competition is surprisingly fierce.

Some of those core trophy properties, like the Hancock Tower and Bay Colony Corporate Center, made headlines when they traded in 2010. But while there has been an uptick in sales, the market for trophy properties is still limited.

“We’d been anticipating a flood of properties to the market that never happened,” said William Gause, director of acquisitions for Leggatt McCall Properties. “That created a bit of a scarcity in premium product and led to competition on trophy assets, which has driven yields to 2007 pricing levels, not a phenomenon we anticipated.”

‘Capital Is Not The Issue’

A new report from PriceWaterhouseCoopers says commercial property sales nationwide will escalate during the next three years as investor confidence climbs, driving a broad market recovery. Buyers, spurred by employment growth, will move to capitalize on prices before interest rates rise and competition pushes up prices of office, industrial, multifamily and retail properties, according to the survey of real estate investors.

The Greater Boston office investment sales market recorded more than $2.3 billion in sales last year, doubling the dollar volume achieved in 2009, according to information from Lincoln Property Co. Additionally, the number of office sale transactions in 2010 increased by 152 percent from 2009.

But the increase in volume came at the expense of value. At an average of $143.78 per square foot in 2010, the year-over-year decline in value was approximately $20 per square foot, according to Lincoln.

But even as values sank, there has been a surprising lack of underperforming properties in the local market, contrary to expectations at the beginning of the country’s economic nosedive. Owners of troubled properties with ugly vacancy rates have not been forced to divest, and instead have held on to non-performing assets in the last few years. And by holding on to properties, some were eventually able to right the ship and stabilize their buildings, according to David Begelfer, chief executive officer of NAIOP Massachusetts.

“Capital is not the issue,” Begelfer told Banker & Tradesman. “Right now it is the question of product. We have a lot of investment funds that have been ready to buy. You’re going to see less of a downside and probably not the big-yield upside, but there’s a lot of interest from institutional owners to buy at reasonable cap rates.”

And according to William McCall, founder of McCall & Almy, pension funds are willing to pay top dollar for core properties with little risk in desirable locations. He said that although institutional investors generally prefer more of a return than the 5 or 6 percent cap rates they are now getting, those funds will accept a smaller return in exchange for the comfort of knowing they are investing in solid real estate and can look forward to another 5 or 6 percent in future appreciation. McCall also sits on Massachusetts’ Real Estate Committee of the Pension Reserves Investment Management Board.

Top Down

Thus far, a lot that has come to market has been far into the suburbs, mostly buildings that are not well occupied and need upgrades, said Michael Smith, managing director for Jones Lang LaSalle.

“While there’s money for that, it’s not as deep a pool of investors,” as exists for trophy properties in core markets, Smith said. “There’s a deep pool of capital seeking … well-leased, well-located, good-credit tenants.”

Non-core assets that are only partially leased and in obscure locations have experienced dramatically less interest, creating a bifurcation of markets between the core and the value-add properties. But there has been a slight recovery in property values across the board because of an overall lack of inventory – a fact that could motivate more potential sellers to finally bring their properties to market.

Gause said he expects more of those non-core assets in the market over the next couple of years, partly as banks realize they cannot continue to extend maturities, sending additional non-performing properties to the market. This could lead to improvement in both the higher and lower ends of the spectrum, as scarcity of high-class product both pushes prices up for core assets and creates demand at lower levels from those unable or unwilling to pay top dollar for more premium assets.

“There’s been an expectation that in light of the perceived recovery, more sellers will want to take advantage of the returning appetite and put assets for sale,” Gause said. “For core assets, we’re back to 2007 pricing levels. If you look at return expectations, those are clearly back to 2007 levels,” with cap rates in downtown trophy properties back to 6 percent. “I think that’s indicative of a significant amount of capital in the market chasing deals.”

But holding back the real estate market is the fact that the fundamentals of the leasing market have not seen much improvement, with significant vacancy in both downtown and suburban markets, Gause said.

However, according to NAIOP’s Begelfer, the good news is that financing is available at rates that are attractive.

“You have to put equity down, but the debt won’t be as expensive,” he said. “There are more cases where you might find all-cash buyers,” because institutional buyers do not necessarily leverage purchases.