Commercial real estate in 2007 had analysts recalling their Dickens. “It was the best of times, it was the most Â… questionable of times,” said David Begelfer, chief executive officer of the National Association of Industrial and Office Properties, an association of commercial real estate professionals. “A tale of two halves” was how Mary Kelly, a senior vice president at firm Meredith & Grew, the real estate services firm, summed up the year.
It started with a bang last February when the Blackstone Group bought Equity Office Properties’ portfolio, a sale that included over 11 million square feet of plum Boston-based assets like Rowes Wharf, Center Plaza, 60 State St., 225 Franklin St. and 125 Summer St., valued all together at about $4 billion. That deal made Blackstone Group, one of the world’s largest private equity firms, into the largest property owner in the Boston area, and signaled the start of a season dominated by large portfolio sales aggressively marketed to private equity firms.
Fueled by abundant liquidity and narrowing risk premiums between equity and commercial real estate debt in the first two quarters of 2007, investment sales seemed poised to exceed even the unprecedented successes of the previous year, whether measured by the number of transactions, sales volume or price paid per square foot. Halfway through 2007, investment volume had reached $9.6 billion, perhaps only a sale away from matching the $11 billion volume set for the entire year in 2006.
Then, with the release of a sobering quarterly update from Moody’s in April, investors took pause. By August, commercial mortgage-backed securities had begun to unravel. Lenders restructured their rates, spreads and equity requirements, or sat back and waited for capital market volatility to settle, effectively choking off credit and deflating investment sales volumes. Lower sales volumes and the uncertainty over pricing and return requirements brought in the wake sent the commercial real estate market on a choppy sail through the second half of the year.
“To understand what happened in commercial real estate in 2007, you have to understand what happened in the wider national economy,” said Arthur Jones, an economist at CBRE Torto Wheaton Research. “Capital markets rejected the notion of funding investments. Fundamentally, that has wreaked havoc.”
It is a testament to the strong fundamentals of the Greater Boston commercial real estate market that, in spite of headline-grabbing economic turmoil, the volume of investment sales in the area covering all property types and geographic submarkets achieved a record level of over $12.5 billion at the close of the year. The year ended on a high note with the fourth-quarter sale of a 50 percent interest in One Financial Center to Beacon Capital Partners for $385 million, or $700 per square foot, a respectable rate in the estimation of Meredith & Grew’s Kelly, and one that speaks of the underlying strength of the Boston office market. “Beacon believes in Boston over the long term,” she said.
Although the current credit crisis may have buffeted many highly leveraged players aside, all-cash buyers (such as pension funds) and moderately leveraged buyers (such as REITs) buoyed the local market through its most successful year since the start of the new millennium. Attracted by the currency advantage brought by a weak dollar and marginally higher returns compared with Western European properties, foreign buyers made an appearance in downtown Boston, where Irish investors acquired the Thomson Financial Portfolio, including 30 Winter St., 27 School St. and 141 Tremont St., a suite that accounted for 68 percent of sales volume in the third quarter of the year.
Low-leveraged buyers are attracted to the area by the sound leasing fundamentals of Boston’s capital real estate market said Rick Cleveland, a director of research at real estate services firm Cushman & Wakefield. “We have strength from a supply standpoint in that ours is a very conservative market. It’s hard to develop, and that keeps competition up, which in turn keeps the prices of rent up.”
Cleveland pointed to the lack of empty buildings in Greater Boston as evidence of the area’s ability to attract and keep businesses. “We have stable sectors of the national economy headquartered here – money management, life sciences, high technology, legal services, education – that combine to make this area a good investor’s market.” Raymond Torto, principal at CBRE Torto Wheaton Research, rates the greater Boston market as healthy, if lean. “To a great extent, the city is in fine shape, but it is not a growth stock. It’s a value stock,” he said.
Cautious optimism regarding the local commercial real estate market was rewarded at the close of the year by key leasing indicators – vacancy and net absorption rates – that pointed to strong tenant demand in 2007. The fog rolling through capital markets had not dampened velocity (signed lease activity) in Boston, Cambridge and the suburbs, where it appeared that the submarkets had finally recovered from the recession of 2001 and 2002. Records were broken and congratulations exchanged among investors as Boston’s vacancy levels dipped into the single digits, from 11 percent down to 8.7 percent, reflecting the absorption of 1.2 million square feet of commercial space by the year’s end. Cambridge held steady at 11.6 percent vacancy throughout the year due in large part to the opening of 301 Binney, a Biomed laboratory that added 420,000 square feet of unleased space to the town’s total supply, bringing the net absorption for the year down to about 370,000 square feet. It also injected what Kelly calls “a healthy block of availability” into the Cambridge market. She named the year-to-date absorption of 4.2 million square feet in the suburban market as the brightest success story of 2007, when aggregate vacancy rates fell from 20.4 percent to 17.7 percent, signaling full recovery for a submarket that had been suffering in the doldrums of a seven-year slump. “They broke that 20 percent barrier, a psychological barrier that meant a lot to the industry,” she said.
Much of that absorption comes as a result of organic growth of businesses already located in the Bay State.
Flurry of Activity
In August, IBM completed a long-term lease for over 490,000 square feet in Littleton to operate as a campus to which most of its 5,000 Massachusetts employees will be transferred. Also in the third quarter, Instrumentation Labs signed a lease for 400,000 square feet of space in Bedford. Lease renewal and corporate expansion dominated the leasing velocity of Cambridge and Boston as well. In Cambridge, the biggest lease of the year was Akamai’s renewal at 4 and 8 Cambridge Center, where the company expanded from 175,000 to 250,000 square feet. In Boston, leasing velocity was set by tenants in the city’s traditional law and finance sectors, including the lease of 415,000 square feet at 800 Boylston St. to Ropes & Gray, 220,000 square feet at 53 State St. to Fidelity and 215,000 square feet at One Post Office Square signed by Putnam Investments.
The steady tenant base did not mean that demand was slack, however. A flurry of leasing activity early in the year led landlords to press for more aggressive rates so that by the end of the year rents began to spike. The average asking rent in greater Boston grew from $38.07 in 2006 to $53.40 in 2007. Higher rents compelled companies to seek more affordable locations in Class B office space, resulting in a narrowing of vacancy rates between Class A and Class B space. Analysts almost uniformly agree that given the area’s tight geography and a lack of new alternatives, rents are unlikely to fall anytime soon. This phenomenon is a boon to the area’s developers, according to Raymond Torto, who remarked that “rising rents making it possible for people to build because the numbers work. Best incentive of them all, right?”
Although the office market remained in trim good health through the year, it was, unfortunately, an exception in a weakening economy. Other sectors of the commercial real estate market were more vulnerable to the recession in housing and its insidious impact on domestic balance sheets. The industrial sector stalled, ending the year with 9.4 percent vacancy, the same rate it began with in the first quarter. Retail vacancy rates rose from 8.7 percent to 9.8 percent as holiday shopping figures failed to meet economists’ most modest expectations.
Indeed, with a nod again to Dickens, “Modest Expectations” would be a fitting title for the coming year. Arthur Jones at CBRE Torto Wheaton Research sees 2007 as a fair year, but one that made no promises for greatness in 2008. “I think, heading into 2008, we’re cautious. We had a pretty stable year. It will be remembered for that,” he said.
