01/08/09

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Betting the office

There could be rougher times ahead for South Florida's office market. But developers are debating the wisdom of foraying into other sectors and diversifying their real estate portfolios.

While the Miami office market remained strong in 2007, Broward saw office vacancy rates rise. Palm Beach County's office market, meanwhile, is still sluggish due to the residential downturn.

The market outlook, combined with a reserved CMBC market, is leading some financial gurus to conclude something's got to give — and it may be the makeup of real estate portfolios.

"There is fear amongst the typical non-recourse borrowers who have office buildings. Life insurance companies have become increasingly conservative with their real estate investing strategies due to the lack of competition, so office owners are struggling to figure out the next step. They don't have Fannie Mae or Freddie Mac like multi-family owners do," says Michael Brown, managing director at Meridian Capital Group, a commercial brokerage firm with offices in Boca Raton.


Mixed signals

Still, a closer look at South Florida's office market reveals Miami developers are enjoying positive absorption, healthy rent growth and substantial new office construction. Overall vacancy rates sit at 7 percent with a favorable outlook, thanks to international trade, tourism employment growth, and two successive mild hurricane seasons, according to CB Richard Ellis.

With demand remaining consistent, office construction activity has actually increased in Dade County, primarily in the Brickell and Downtown submarkets. Rents are climbing throughout South Florida, CB Richard Ellis reports, and unprecedented rental rates are expected through at least 2009 when the new space becomes available.

Still, experts suggest Broward and Palm Beach may see rougher days ahead.

In Broward, three new office projects recently came online, with more new space opening up later this year. Broward's overall vacancy rate experienced a year-over-year increase of 3.9 percent, partly due to speculative construction and supply outpacing demand, according to CB Richard Ellis.

Palm Beach County vacancy rates have nearly doubled since 2006, coming in at 15.3 percent in the fourth quarter of 2007. As a result, rental rates are decreasing and concessions have returned. The good news is there are no signs of overbuilding there. CB Richard Ellis predicts that planned projects that have not yet gotten out of the dirt may see longer delays in the face of credit challenges.


Diversifying office portfolios

In light of the forecasts, office developers that haven't already diversified may do well looking into other property types, just in case a slump officially begins, said Lewis Goodkin, president of Goodkin Consulting, a Miami-based real estate and financial services advisory firm. In fact, he says, the trend toward mixed-use has already led developers of all property types to diversify more.

"The key is what to diversify into and when," Goodkin says. "The problem in today's environment is residential development, which has a tremendous impact on the demand for commercial uses. If there aren't enough rooftops being built, that affects retail and office occupancies across the board. Sometimes it's best not to do anything at all in certain market conditions. Sometimes it's better to buy distressed land and hold it."

Where's the money?

Too many inexperienced office developers are over-leveraged and heading for trouble, said Michael Cannon, managing director of Integra Realty Resources, a commercial real estate consulting firm with offices in Miami. Some are going into bankruptcy, he added.

"I am surprised lenders gave some of these developers money in the first place because they didn't have the equity capital to do the project right," he says. "They are almost what I call flippers. Quality office developers are sustainable in this market."

Although there are still lenders willing to lend, Brown says securing capital has become a "who you know" market. Commercial mortgage brokers have become much more valuable. Multifamily properties, even in this market, have the most aggressive sources of financing available at this time, which, Brown says, is a key reason office developers are diversifying.

"Several smart office owners sold out of their investments in 2006 and 2007 to office condo developers, many of whom are now struggling to sell off the inventory — not due to a lack of demand, but to a lack of available financing for the end units," Brown said. He notes opportunities lie with deep-pocketed investors who can potentially pick up properties at lower prices due to the lack of aggressive financing sources.


Long-term diversification

While some developers — like Stiles Corp., Rockefeller Group Development and Sky Development — have long been diversified, experts say the narrowing gap between bidding and asking prices is becoming a new reality that may force some level of diversification. With mixed-use projects gaining momentum in South Florida, office developers — as well as other developer types — may remain diversified even when the office market sees new growth.

"There's no question cities are increasingly encouraging mixed-use development. Developers can address many opportunities on the same site," Goodkin says. "Of course, some developers will just stick to their own business because that's their strength. There's nothing wrong with that either, but it's smart to be positioned to do mixed-use projects in South Florida."


A different view

John Bell, managing partner of Miami commercial brokerage firm DTZ Rockwood, isn't convinced that traditional office investors will rush to diversify their portfolio. In general, he says, developers are drawn to one type of product. The exception is large institutional developers and investors.

"Some office investors may stop buying, and developers may put projects on hold until the market cracks," Bell asserts. "When the market is down, other investors may swoop in and buy because they see a great long-term market. We are seeing the opposite of diversification. If office investors believe times are getting rough, they would be more inclined to buy."

Diversifying brings in new revenue streams for developers and investors, much the way it does for other types of businesses. Once everybody recognizes that diversification is the new reality, Brown says, the market should start to see more activity.

"Diversification requires a level of market savvy which many of the newer generation of investors don't have yet," Brown argues. "Seeing how they respond to the challenges or working with different asset types in different markets will make for very interesting times for all of us. We hope for the best."