Sale prices of office buildings have been rising, even as occupancy rates have been falling.

But even though some in the real estate industry have been saying that this divergent trend is pumping a "bubble" in the office investment market, this activity is no more than "rational exuberance" on the part of investors, according to an end of 2002 report by Grubb & Ellis Co., PNC Real Estate Finance and Real Capital Analytics.

The problem is limited to a small set of investors buying the best properties in a handful of markets - it is not a widespread problem, the authors of the report maintain. One investment broker quoted in the report said: "For every investor who thinks there's a bubble, five others outbid him."

The study includes transaction and leasing data and interviews with leading players in commercial real estate. "Our findings clearly indicate that investors are exhibiting rational exuberance as they consider investment options, choosing to buy the best assets in the best markets for high prices in order to avoid market risk," said Bob Bach, Grubb & Ellis’ director of market analysis.

"This is a rational response to historically low mortgage rates, the lack of compelling investment alternatives, and the willingness of investors to trade lower yields for lower risk in the post-bubble, post-Enron era."

Nicholas Buss, PNC Real Estate Finance’s group manager of market research, quoted one respondent as saying that “fear is outweighing greed and no one wants to screw up.”

“If they are wrong,” Buss said, “investors want to be wrong on the upside, and they are willing to accept -- and pay for -- a lower yield to move down the risk curve in order to take on less risk."

The reasons for the continuing trend are relatively straightforward, Buss said.

"Based on unattractive investment alternatives, real estate clearly looks to be the best of the worst,” Buss said. “Real estate is a hard, tangible asset that has historically thrown off a 7percent to -9 percent income return (in the form of current, spendable cash flow) and, in terms of total return, has outperformed most other major asset classes over the last one-, three-, five-, and 10-year investment horizons."

With interest rates falling to historic lows, Buss said, the spread between finance rates and cash yields is the widest it has been in many years. The result, paying higher prices for properties with stable or marginally declining cash flows can be justified in terms of the total risk-adjusted yield.

The study found that the District of Columbia, Midtown Manhattan and Southern California topped the list of primary markets in which investors are willing to bid aggressively for the right assets. The District of Columbia may be the last market where the opportunity play is alive and well as buyers bid aggressively for Class B and C properties as well as Class A.

Bob White, president of Real Capital Analytics, said the study told "a tale of two markets," contrasting the stable Class A properties with the vast universe of other properties more subject to leasing risk. This latter category includes Class B or poorly located properties in primary markets and the vast majority of properties in secondary markets.

"There is some migration along the risk curve as buyers excluded from the first tier take on riskier properties simply to get their money placed in real estate,” White said. “But there is little evidence to suggest that this is happening on a systemic basis. On the contrary, there still appears to be a gap between buyer and seller expectations for second tier properties and secondary markets, with sellers choosing to refinance rather than sell into a cautious market."

The authors of the report expect some of today's more aggressive investors, notably those using floating rate debt and not anticipating a long-term hold, to experience some discomfort when the capital markets become less friendly to real estate. This could happen when the economy gains momentum causing interest rates to rise and other investment categories, such as stocks and bonds, to look more appealing.

"Because the capital markets shift more rapidly than the leasing markets, these owners will not be able to offset rising interest rates with rising rental rates soon enough to avoid deterioration in their cash flows," said Elizabeth Ptacek, PNC's senior analyst for marketing research. "This could result in some distressed properties coming to market in 2003 and 2004, but nowhere near the volume that capsized values in the early 1990s following the last recession. Most investors appear to be buying with their eyes open."

Published: January 16, 2003

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