As anticipated, 1^st Quarter NPI Office returns came in at a pedestrian 1.96%, continuing a downward trend.  From a regional perspective, the South region posted the highest total quarterly return at 2.14%, while the Mid-West region continued to lag the pack.  CBD office assets again outperformed their suburban counterparts.  The 1^st Q 2008 office sector results are off sharply from returns posted earlier in 2007, but still outpaced all other property types over the trailing 12-months.

Relative Valuation…How low is too low? Income return spreads to 10-Year Treasuries have fallen steadily over the past several years for those areas with the largest inventory of office space.  In the most recent quarter, income spreads “jumped”, perhaps impacted by a valuation “lag” created by the rapid decline in Treasuries yields from quarter-to-quarter or a sign of a downward valuation correction in the offing.  Our interpretation of historical NPI relative returns in combination with the changes in capital market conditions is that office property appreciation relative to other property types and assets will be a challenge for most metro areas.

Holding income growth constant for a moment…The futures market is now pricing the five-year forward 10-Year Treasury Note at a 4.75% yield, nearly 100 basis points above current levels.  A rise in yields on risk-free assets would dampen appreciation, all else equal.  Moreover, those MSAs that have relative valuations near or below all-time lows over 10 Year Treasury Notes would have even lower appreciation prospects should their income return spreads widen toward historic average levels.  At the same time, compression in risk premiums within second and third tier markets over the past several years could reverse trend.

Can returns be salvaged with income growth? Before bottom-fishing in those markets where office valuations appear to have corrected above the relative return trend, it is critical to evaluate expected income growth prospects.  We combine the implied forward Treasury rate data and the average income return spread data with the intermediate-term growth forecasts from well-regarded forecasting groups to derive an (albeit rudimentary) total return outlook for the largest office markets.

Such forecasts impute a strong measure of job growth in their forecasts and imply a healthy relative return outlook for markets such as Dallas, Atlanta and Philadelphia office markets but a far less optimistic outlook for New York, Washington, DC, Boston, San Diego, and Baltimore.

Fiduciaries’ Response. Real estate investment fiduciaries should consider weighting their office property investments out of those markets where relative valuations are high and growth prospects are low (i.e., overpriced) and towards those that are reasonably valued relative to historic averages and that have promises of healthy income growth.  With many prominent markets now or recently “overpriced”, and with the CMBS/Wall Street crowd now demanding performance, it would seem that a bias toward (overpriced) “dominant markets” may yield to what we would call “accounting” driven markets.  It is happening in the stock market.  It must happen in the real estate market.  With the ever growing need/demand for yield, and a better understanding of risk, office investors will have to “return to the numbers”, and not brochure pictures.

Dennis Duffy, MAI, Principal

William Bott, CFA, Senior Consultant

Joseph Buttarazzi, Senior Consultant

RCDH & Co.

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