Building Investors Bought a Lot of Risk in 2005 - Falling CAP Rates Tell Story

In technical terms, 2005 was the year of cap rate compression in commercial real estate investing. Less technically, it was the year of investing dangerously.

For a second straight year, it was boom times for office building sales in the Bay Area. Nearly a dozen high-profile buildings traded, including Northern California 's premier Class A highrise,

Underlying the buying binge was a near abandonment of a metric used by savvy investors for decades -- the cap rate.

The cap rate is based on a building's net operating income divided by its price. Cap rates are a simple way to gauge a building's worth by numerically answering the question: Can this building's current cash flow justify today's sale price?

The lower the cap rate, the higher the risk.

Cap rates have dramatically declined in this decade. In 2000, buyers and their lenders were comfortable with cap rates in the 8 percent to 10 percent range, but those days are long gone. In 2005, some high-profile buildings traded at cap rates under 5 percent. As majestic as 555 California is, its cap rate was somewhere between 4 percent and 5 percent, according to investment specialists at the leading brokerages who tracked the deal.

Veteran investor Hal Ellis, a principal at San Francisco-based Ellis Partners, said today's cap rates are near a 50-year historical low. He maintains they are a reflection of global and local economic factors and essential in evaluating buildings. He has done deals in the 3 percent to 5 percent cap rate range partially because they provide upside opportunities for Ellis Partners.

Ellis hopes to raise his buildings' cap rates by upgrading the buildings as a way to increase occupancy and rents.

"For us, the important variable is what we call our free and clear cap rate. We figure our return on total costs after we have made our improvements, then look at that the building's total income," Ellis said. "Our return on total costs is more important than that initial cap rate."

It's not a new strategy, but partially explains why cap rates are going down. More investors, especially new players in the market, are willing to take on risk to try to add value to their acquisitions. But that can only explain some of the richest 2005 deals.

Bentley Holdings' purchase of the former Federal Reserve Building at 400 Sansome St.doesn't have a cap rate. The building has been empty since law firm Orrick Herrington & Sutcliffe moved out in 2004. Bentley paid a hefty $46.8 million for the building and has yet to sign a tenant.  

Lincoln Properties is gambling $64 million on 601 California St., a building with a 5.5 cap rate and 43 percent vacancy. Less risky was Kennedy Associates' acquisition of 303 Second St. for $237 million for a 7.25 cap rate.  

Exuberance, Rational or Otherwise

"A city like San Francisco has some of the lowest cap rates in the country," said Jack Ducharme, managing partner at Julian J. Studley's San Francisco office. "The rates are higher in Chicago , Dallas and Denver .

"Driving this is a limited supply of buildings and the hopes of higher rent," Ducharme said. "Short term, there is not a lot of gas in leasing, this market still lacks job growth. We thought 2005 was when we would see the pedal to the metal on leasing, but the kinds of rents needed to justify some of these deals were not realized. We expect a slowdown in building sales in 2006."

Ducharme said investors who are paying big bucks for low-cap-rate buildings have faith in San Francisco 's economic resilience, so they will be patient and wait for the big rents that will justify their big-ticket purchases. He estimates the overall San Francisco cap rate at 6.5 percent, with the class A cap rate at 5.5 and the Class B/C market at 7.5 percent. Loop Net, a national service, has the city's cap rate pegged at 7 today. Five years ago, the rate was closer to 10.

Part of the push behind the cap rate compression is the heavy pressure to do deals today. The amount of capital seeking to invest far outweighs the number of buildings available. Low interest rates encouraged national and regional investors to compete with affluent offshore individuals and groups for the Bay Area's best buildings in 2005.

"There were 20 to 30 offers on property, and people were ever more aggressive on pricing and underwriting assumptions. This pushed down cap rates," said Colin Yasukochi, the research director at Grubb & Ellis who estimates the city's overall cap rate today is around 7. He said the city tallied a 20 percent rent jump in 2005, which led investors to believe the Bay Area is in the early stages of an office boom and the time to buy is now.

Kid Stuff

Another factor may be the changing nature of the investment groups themselves. Adviser groups representing large institutional investors get a fixed amount of money to invest annually and they look bad if they don't put the money in play. They ask themselves daily what's worse: if they don't place the money or if they make a bad investment that tanks in five years.

"Today, all the acquisition guys are young. It's a stepping stone for many of these guys, and they will be in these positions only for a year or two. If they pay a 5 cap rate now, they know they won't have to live with it if it goes sour," said Christopher Aust, a director in Cushman & Wakefield's capital markets group. "In the old days, these deals were done by veterans who sat around at lunch in a clubby atmosphere. They held these properties for 10 years."

Aust's deals in 2005 included selling160 Spear St., which went for $57 million and a 7.75 percent cap rate. He also was involved in the 303 Second St. deal, with its relatively solid 7.25 percent cap rate. There wasn't intense competition for the building because of its suburban-style campus in the midst of the city, Aust said.  

Flip Flops

Many real estate investors today are thinking short term and are practically ignoring cap rates. In a heated market, they can hold for a year or two and flip the building for a big profit, despite a questionable cap rate.

That partially explains the deal for the Bank of America building.

New York investors flipped the trophy in September after less than 12 months to Hong Kong 's Hudson Waterfront Properties. The seller, Pacific Gold Equities, made more than $200 million on its investment.

"Today you can make more in one year on a building than the previous owner did in the prior 20 years," said John Grassi, head of Spear Street Capital. "In the case of the Bank of America building, tax considerations may have also driven the deal.

"We bought the Adam Grant building, and it had over a 10 cap, but that was not very meaningful," Grassi added. "In some cases cap rates can be misleading."

Grassi is a former chief investment officer for Shorenstein Co. who started his own investment firm targeting low-cap-rate properties. He flipped San Francisco 's historic Adam Grant building at the corner of Bush and Sansome streets after holding it just a year.

He knew JP Morgan Internet's lease was up in 18 months and the building would be 30 percent vacant, so the 10 cap rate when he bought it was not a good long-term barometer. In an improving rental market, Grassi was able to sell the building for $270 a square foot, making a profit.

"We don't focus on cap rates, we're not looking at core assets. For us, if it's partially leased and in a state of flux, we're interested."

Cap rates are expected to be in flux as well. After a half decade of falling cap rates, many investors and brokers expect the compression to subside in 2006 with rising interest rates and fewer buyers willing to take risks on low-cap-rate property.