Just as the recession has been tougher on Main Street than on Wall Street, it has also hit two distinct types of office properties disproportionately. One type of office building has done surprisingly well, and one has suffered enormously. More than 75% of office properties are in the first category -- but they are subsisting on the primary revenue source of the impaired other fourth.

And here is the distinction: tenants. Those office buildings that had a higher occupany rate have attracted more tenants during this recession. And for those office buildings with lower occupancy rates have lost more tenants during the same period.

Since the start of the recession, all of the multi-tenant office buildings that are currently 80% or more occupied in 50 of the largest metro areas have posted 170 million square feet of net absorption and have seen their vacancy rates decrease 2 percentage points on average since January 2007, according to CoStar Group data analyzed using its Property Analytics product.

All of the damage, it appears, has fallen on buildings with less than 80% occupancy. Those buildings have posted a negative 128 million square feet in net absorption and their vacancy rate has skyrocketed since recession's grip started tightening on the economy.

According to one of the largest property owners in San Francisco: "I can tell you from first-hand experience that this analysis is spot-on: there's a balkanization occurring, and our market is getting impacted more than severely than most. Here, it's all about views: for Class A buildings where you can see the Golden Gate Bridge or Treasure Island, there's very likely competition for your space; for non-view space in commodity buildings, you can barely attract interest at any price."

And the demarcation appears to be a pretty unforgiving line to cross.

"We recently purchased a B+ bldg in the Baltimore CBD with 75% occupancy at the time of purchase. This was a classic value-add opportunity with a very well located building, but one that had suffered from prior mismanagement and neglect, where we could bring our real estate expertise in a market where we are part of the community," said Alan C. Grabush, principal, director of marketing & acquisitions of CSG Partners LLC in Baltimore. "Now, 10 months later come the end of October, occupancy will be 65%, notwithstanding our on-going CapEx renovations and investment into the asset."

"I think the moral to the story is that it is more difficult and takes longer to turn around a building that has a negative history and perception, despite investing significant dollars and doing everything 'right' by a proven developer who is well known in the market," Grabush said. "This was evidenced by being a day late and a dollar short when one of our lead tenants decided to relocate in favor of renewing. Hence, the 10% decrease to occupancy. We have even moved our corporate headquarters to the building to send a strong message to the tenant and brokerage marketplace that the prior days of mismanagement and neglect, well, are history. And in a market like we live in today, any prospects that are out there will gravitate to what (they perceive to be) 'successful' buildings with a track record of strong management and ownership. And why wouldn't they? They have their pick of the litter."

"The second moral to the story," Grabush continued, "it's an uphill battle with this type of investment -- so your basis better be right, affording you the time to appeal to and attract more prospects over a prolonged lease-up period."

Industry executives we contacted for comments and analysis suggested there may be other variables involved that account for the huge distinction. For example, the data does not show when the properties first reached 80% occupancy and in no way indicate that low-occupied properties cannot reach a tipping point. But the data does suggest that once they do, the chances for stability and success could increase -- or just the opposite, if they fall below the threshold, it would be harder to hang on to tenants.

Size, too, may play a factor, but it is not certain. The average size of the best-performing properties was about 103,000 square feet, compared with an average size of 80,000 square feet for the worst performing. However, among buildings that were larger than 100,000 square feet and were currently less than 40% occupied, about half the tenancy pulled out since the start of the recession.

It does not appear to be a question of class, either. Class A properties made up less of a percentage of the most occupied properties (24%) than the least occupied properties (28%). Class C made up a higher percentage of the most occupied. Of those with 80% or higher occupancy, 20% were identified as Class C properties, compared to 16% with those less than 40% leased. Even the most occupied Class C properties showed vacancy rate declines from 6% to 3.6% and posted positive net absorption of more than 1 million square feet on average in every quarter of the recession. The Class C properties less than 40% occupied showed vacancy rate increases doubling.

Others suggested age may also be a determining variable. That may be, but in opposite ways than expected. It was suggested that tenants preferred and may indeed be flocking to newer, quality buildings with more modern amenities. However, the data suggests that just the opposite may be true - they are flocking to more established buildings. The average age of the better-performing, most-occupied buildings was 35 years vs. 28 years for the under-performing least-occupied buildings.

"I think it may have a lot to do with new buildings which, understandably so, require higher rental rates, and are therefore, more difficult to lease today. As a result these buildings, which already have a lot of vacancy (if they were built spec) remain vacant because the other mature/older buildings have substantially lower rental rates," said Rick Williamson, senior vice president leasing of St. John Properties in Baltimore. "In addition, companies are not willing to incur costs to move in today's environment and therefore, newer buildings are not seeing prospects."

It was not clear though that rents were a primary determining factor overall. One would think that the buildings with higher vacancy would cut their rates more aggressively to "buy occupancy." That does not appear to be the case. In the set with the highest occupancy, asking rates are down 4.35% year over year; in the set with the lowest occupancy asking rates are down just slightly more at 5%.

Really, the most common measurable variable that the best performing properties have had over the worst performing is a full house. The more occupied the property, the better it has held up in the recession.

"It is likely that what you are seeing is real," said William C. Yowell, vice chairman Investment Properties | Institutional Group of CB Richard Ellis' Capital Markets Group in Atlanta. "We have been experiencing a flight by credit tenants into buildings/landlords with strong balance sheets and overall stable capital stacks on their buildings. This is an understandable reaction given the turmoil in the commercial real estate markets. Our capital markets professionals are receiving numerous calls from our tenant rep brokers asking questions about the viability and capital stack of various landlords and buildings, confirming a flight to quality."

Andrew Schaffler, a research analyst with Cohen & Steers, a New York-based manager of real estate mutual funds, is seeing the same thing with real estate companies in their portfolios.

"I believe tenants are flocking to strong and financially stable sponsors," Schaffler said. "For example, we have seen REIT office landlords in New York City maintain 95% plus occupancies with the market falling below 90%. REITs have shown access to capital markets, are strong sponsors, and have largely taken impairments to asset values that private players are still working through. A financially stable sponsor can afford to spend CapEx dollars to build out a tenant's space, which may be luring tenants to these buildings. Same goes for buildings with high vacancy rates - if tenants are concerned about a landlord's ability to cover debt service they may wish to partner with an operator who is less 'stressed.'"

Steven Sandler, CEO of Rye, NY-based Crosswind Capital and a regular contributor to Watch List, said just looking at occupancy numbers for the most occupied could be misleading, but tell a dire story for those on the bottom.

"Occupancy is the most easily manipulated number in the landlord's arsenal, and you need to closely examine the actual rent roll to unearth the truth," Sandler said. "Let's face it: as any college kid with a backpack on a summer trip through Europe knows: 'a place to crash for free, is better than a place you have to pay for.' Commercial tenants are no different."

But Sandler added, "As long as borrower's can grab enough tenant share to keep their assets above water, then that further disconnects the bid/ask spread for commercial properties at the top level. However, this is a game that eventually the truly impaired borrowers will lose."

Quarter With 80% or More Occupancy With less than 80% Occupancy 2007 1Q 22,873,008 -12,920,892 2007 2Q 25,149,649 -5,976,538 2007 3Q 24,404,453 -11,153,115 2007 4Q 26,154,970 -8,872,513 2008 1Q 16,955,126 -14,587,397 2008 2Q 21,034,652 -10,912,585 2008 3Q 12,386,149 -11,599,460 2008 4Q 13,111,444 -11,007,869 2009 1Q 2,100,175 -19,833,040 2009 2Q 5,588,769 -19,730,882

 

Mark Heschmeyer, Co-Star, 9/30/2009