BEST OFFICE MARKETS
Property Value = 200,000/0.08 = $2,500,000 Given the above formula, rent growth can help in achieving double-digit returns in two ways. First, if the rent a property commands in the market increases, then the NOI of the property, and the numerator of the above formula, will increase, thereby resulting in a higher market value. At the same time, strong rent growth will contribute to compression of market cap rates and, therefore, to a lower denominator in the formula above, which will result in an even higher market value. Strong rent growth implies a tight office space market in which demand for office space outstrips available supply of office space in the market. Such supply shortage conditions are manifested in low vacancy rates. Within such environment of rising rents and low vacancy rates investors tend to be more optimistic about future cash flows and property values, and, hence they consider office investments less risky. As empirical evidence has shown cap rates tend to compress when the market is strong. Within this context, if office market rents are growing, after an office property is purchased, it can be reasonably expected that cap rates will be declining (assuming all other factors that affect cap rates movements remain constant). Core (low risk) office property investments are typically investments in fully-leased, or almost fully leased, high-quality office buildings at strong locations. The tenants are typically companies with strong credit rating holding long-term leases. Due to long-term leases, the income generated by these properties does not increase at the same rate that market rents grow, but according to a rate, which is tight to the changes in the CP,I as defined in the escalation clause included in each contract. These clauses may limit growth in the income generated by the property when rents grow rapidly but on the other hand they keep that income growing even when market rents are declining. Office properties that are occupied with tenants with short-term leases, let’s say 3-year leases, can benefit more from rapidly increasing market rents, which can be passed on to existing tenants when their leases come up for renewal or to new tenants that are interested in leasing up space. Notice that rent prospects represent a comprehensive indicator of the prospects of an office market as it incorporates the economic, demand, supply, vacancy and rent behavior aspects of the particular market under consideration.
The above discussion demonstrates why rent growth is the most important criterion in selecting best office markets for double-digit returns.
Property acquisition price: 2,500,000
In selecting best office markets for double-digit returns, it is important to have in mind the characteristcs of the markets that are more likely to have strong rent growth prospects: 1) Household income is predicted to increase (higher household income implies higher demand for service, which can fuel expansion of local firms or birth of new firms in the service sector) In selecting best office markets to invest in with the objective to achieve double-digit returns it is important to have reliable office rent growth forecasts for the markets under consideration. Such forecasts can be obtained from specialized vendors who use advanced econometric models to model the behavior of the local market, and particularly local supply, demand, and rent movements and forecast how these variables will move under the most likely economic scenario for the market under consideration. Vendors most qualified to produce such forecasts are those who have reliable and consistent measurements of the existing and historical office space stock levels, vacancy rate, and office space under construction, as well as reliable historical constant-quality office rent indices. Historical constant-quality office rent indices are more appropriate than average market rents for modeling the behavior of office rents in a local market, because the former control for changes in the quality-mix of properties involved in lease transactions through time, while the latter does not. The accuracy of office rent growth forecasts will also depend on how accurate is the forecast for the growth of the local economy, which will be the driver of the demand side forecast of the model.
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