Investors continue to pursue well-leased properties in the best performing markets, and sale prices for prime commercial real estate continues to climb, but the fact that industry fundamentals continue to weaken at the same time has raised concern among investors.

That’s the latest view of the PricewaterhouseCoopers Korpacz Real Estate Investor Survey, which was released earlier this month.

"Even the most optimistic investors worry that the longer the downturn persists, the greater likelihood of widespread income losses," said Peter Korpacz, who is the director of global strategic research practice at PricewaterhouseCoopers.

"Rental rates will fall, vacancy rates will rise, and overall cap rates will fail to offset the resulting drop in income that will occur," Korpacz said.

In spite of such concerns, institutional and foreign investors and real estate investment trusts continued to buy select commercial real estate in the fourth quarter of 2002, which raised prices sharply. Particularly, regional malls and well-leased office buildings in key markets were caught in bidding wars.

Apartments continued to prevail as the most sought after property. Readily available and inexpensive debt has enabled many investors to remain assertive buyers, according to Korpacz.

The majority of recent acquisitions by real estate investment trusts have occurred in the retail sector. By comparison, both institutional and foreign investors have been active buyers of office properties. Foreign acquisitions of U.S. commercial real estate nearly doubled in 2002. More than 80 percent of foreign investment capital has been in the office sector, primarily in central business district towers.

The average sale price paid by a foreign investor is almost $60 million; nearly double the market average.

Manhattan and Chicago have been the beneficiaries of these investments. Specifically, 45 percent of foreign capital was invested in Manhattan, while an additional 20 found its way to Chicago last year. According to Korpacz, fierce competition and investor demand for commercial real estate has raised sale prices and lowered overall cap rates for nearly all properties that offer "credit and term."

However, only the best performing office properties, in the most attractive markets, are of interest to investors. Assets with strong tenancies and limited near-term leasing risk are of greatest value. Despite rising vacancy rates, capital continues to flow into the national central business district office market.

The number of regional malls trading has increased during the first nine months of 2002 throughout the country with the largest concentration of dollars invested in the Midwest. A large percentage of deal flow has been completed in smaller metro areas rather than larger metropolitan markets.

Investors are least interested in acquiring community centers, power centers, suburban office buildings and research and development property, according to Korpacz. The national suburban office market continues to suffer from a glut of available office space. Tenants are negotiating lower rents, high tenant improvement allowances and large amounts of free rent. The survey indicates that an overwhelming majority of participants – 80 percent – contend that concessions are prevalent throughout the suburban office market nationally.

By comparison, last year only 65 percent of participants indicated that such concessions were common. Investors suggest that the process of reverting of sublease space back to direct vacant space will be the next major income-reducing obstacle for office markets to overcome, Korpacz said. Although the rate at which sublease space has been returned to many individual markets has declined considerably over the past several months, sublease space still adds a huge burden to the national office sector, which is already distressed by lack of demand.

Favorable financing terms have enabled small, private investors to compete head-to-head and favorably against major institutions and real estate investment trusts. Toward this end, local buyers account for approximately 40 percent of Southern California apartment transactions, with REITs and institutions representing about 30 percent each.

Furthermore, over one third of investments from the private sector have been concentrated in the West, where a greater proportion of personal wealth was created during the last real estate cycle.

By contrast, foreign investors have favored the Northeast. Southern California, New York, Washington, D.C., and Chicago continue to rank as the most favorable investment opportunities.

Published: January 23, 2003

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Al Heavens writes about real estate and home repair and improvement. He is the author of What No One Ever Tells You About Renovating Your Home: Real-Life Advice For Hassle-free, Cost-Effective Remodeling.