Silicon rally

Institutional investors are snapping up office buildings in markets ravaged by the tech bubble collapse. Do they know something tech investors don’t?

When CarrAmerica Realty Corp. sold a vacant San Jose, California, office building for $5 million in December, the Washington, D.C., real estate investment trust took a $2.2 million loss. It had acquired the 67,000-square-foot, single-story stucco structure back in 1997, when the building was occupied by Comdisco, which went bust after the tech stock bubble burst and filed for bankruptcy protection in July 2001. Don’t suppose, however, that CarrAmerica is abandoning Silicon Valley. It is, in fact, one of the region’s most visible buyers, having purchased eight office buildings in the San Francisco Bay Area for a combined $199 million during the second half of 2004. The company’s Bay Area holdings are now 6.5 million square feet, about a fourth of its national portfolio.

“We have confidence in the recovery in northern California,” says CarrAmerica’s chief investment officer, Karen Dorigan. “It is happening at different rates in different places, but they’re all beginning to come back.” Indeed, more than $5 billion of commercial properties were sold or spoken for in the San Francisco Bay Area in 2004 -- better than twice 2003’s volume.

CarrAmerica is one of a growing number of institutional investors acquiring commercial properties in Silicon Valley and other “tech-wrecked” markets, including Atlanta; Austin, Texas; Baltimore; Boston; northern Virginia; Portland, Oregon; Raleigh-Durham, North Carolina; and Seattle. The buyers include New York’s Teachers Insurance and Annuity AssociationCollege Retirement Equities Fund (TIAA-CREF), the California State Teachers’ Retirement System, the California Public Employees’ Retirement System and Dallas-based REIT Prentiss Properties Trust.

A fitful recovery has clearly begun. And although in many tech markets office vacancy rates remain higher than the national averages of 14.5 percent in central business districts and 19 percent in the suburbs, they’re considerably lower than they were a year ago.

Consider northern Virginia. A few years ago tech companies were dumping millions of square feet of excess space back on the market. In fall 2001, for instance, Cisco Systems put 224,000 square feet of office space in Herndon up for sublet. That’s changing fast. In the fourth quarter of 2004, vacancy rates dropped to 13.3 percent, far better than the 19 percent rate that prevailed a year earlier. At the opposite side of the country, the vacancy rate in Portland fell to 13.1 percent in the central business district and 19.2 percent in the suburbs, from 14.5 percent and 24.1 percent, respectively, over the same period.

Office property sales are also picking up. And it’s not just revived computer or telecom companies that are renting space: Biotech and defense-related companies are filling many of the empty quarters. CarrAmerica, for instance, sold its San Jose building to RAE Systems, which manufactures devices that detect toxic gas and radiation and sells them to industrial users and defense contractors.

Rents remain far below their precrash high. In San Francisco, for example, class-A office leases were approaching $100 per square foot in early 2001; at the end of third-quarter 2004, they averaged $30.72, reports Cushman & Wakefield, a real estate services firm. Still, it’s a nascent recovery, and it could fizzle. “Vacancies are heading in the right direction, but that’s about as far as you can go right now,” says J. Allen Smith, a portfolio manager of Parsippany, New Jerseybased Prudential Real Estate Investors, which has $23 billion in assets. “Most of what you think of as the major technology markets saw a modest improvement in 2004. But that improvement is not translating into the balance of power shifting from tenant to landlord.”

Investment in high-tech goods and services is not increasing rapidly enough to drive a significant increase in employment and hence demand for office space. Robert Half Technology, a Menlo Park, Californiabased recruiter of IT professionals, says that only 11 percent of 1,400 CIOs polled in October plan to add IT staff this quarter. “The recovery has not gained a lot of steam and momentum,” says Prudential’s Smith. “It’s fairly tenuous.”

This cycle differs from real estate’s slow comeback from the wrenching property recession of the early 1990s. Then, many major markets were glutted with empty towers built on spec by overleveraged developers; subsequent high interest rates and a credit crunch helped turn boom to bust. Many sellers had to unload holdings at distressed prices. But once this purging process took place and interest rates fell, the real estate recovery began.

During the late ‘90s boom, lenders showed more restraint than they had a decade earlier. And today owners are paying off their debts at interest rates that remain low, even after recent hikes by the Federal Reserve Board. More owners have managed to hold on to their properties. In many cases, they’ve refinanced their loans at reduced rates; in others, they’ve cross-collateralized vacant buildings with more stable properties. Thus this recovery has begun on a more solid footing. Sellers aren’t desperate, and buyers can’t find outright bargains. “In many places holders of assets are really loath to sell below replacement cost,” says J.P. Morgan Fleming Asset Management’s David Esrig. “And that’s a big difference we’ve had in this cycle versus the previous cycle.”

Buyers are out there. According to a recent report by Deloitte & Touche USA and Rosen Consulting Group, pension funds devoted 5 percent of their assets to property investments as of year-end 2004, up from 4 percent in 2003. The issuance of commercial-mortgage-backed securities reached $92.9 billion at the end of 2004, surpassing 2003’s $76.5 billion. Real estate mutual funds pulled in $6 billion of net inflows last year.

“Notwithstanding the vacancies that you have in these markets, the interest on investors’ part is still extremely substantial,” says Timothy Welch, head of investment sales at Cushman & Wakefield. Thomas Garbutt, managing director and head of real estate at TIAA-CREF, adds, “There are no great bargains out there, but we do see a value play in getting into tech-based markets.”

In the largest tech market, the San Francisco Bay Area, $5.8 billion in office property was sold or put into contract in 2004, up from $1.9 billion in 2003. The still-steep office vacancy rate is improving: It stood at 17.4 percent in the central business district and 22.5 percent in the suburbs at the end of fourth-quarter 2004, down from 20.1 percent and 25.5 percent, respectively, a year earlier. In Boston vacancy rates fell from 14.6 in the central business district and 26 percent in the suburbs in fourth-quarter 2003 to 14.5 percent and 23.2 percent in fourth-quarter 2004. Sales totaled $4.9 billion last year, up from $2.4 billion in 2003. In the tech-filled Route 128 West corridor in suburban Boston, vacancy rates declined from 24 percent in 2003 to 18 percent in 2004.

Among other notable tech market deals: In November the Chicago REIT Equity Office Properties Trust acquired Westech 360, a four-building office complex in Austin (home to Dell), for $28.6 million. At $160 per square foot, the price came in 23 percent above the average of $130 per square foot for the Austin market, which property investment sales research firm Real Capital Analytics of New York characterizes as having more demand from investors than available product. That same month in Lexington, Massachusetts, a Boston suburb, Boston’s TA Associates Realty paid $35 million for the 190,080-square-foot Hayden Woods office complex, whose tenants include Cisco and Motorola. Also in November, Behringer Harvard Funds, a Dallas-based sponsor of REITs, was in contract to pay approximately $46.3 million for the 288,175-square-foot Ashford Perimeter in Atlanta; tenants include Verizon and Noble Systems Corp.

TIAA-CREF, which directly owns $13 billion in real estate in the U.S., Canada and Western Europe, made several office acquisitions in tech markets in last year’s second half. In November, in a joint venture with REIT Boston Properties and Dutch pension fund Stichting Pensioenfonds ABP, TIAA-CREF acquired Worldgate Plaza I-IV in Herndon for $78.2 million. The four-building, 322,000-square-foot property is 75 percent occupied by tenants that include Savvis Communications Corp., Symantec Corp. and Verizon.

“When we look at the demand drivers in northern Virginia,” says TIAA-CREF’s Garbutt, “we see good prospects going forward. These tech markets have just tremendous intellectual capital, and when you see that, the long-term prospects are usually very good.” A few weeks before Christmas, TIAA-CREF bought the $348 million, 845,533-square-foot IDX Tower in Seattle. High-tech tenants include IDX Systems Corp., a provider of IT services to the health care industry.

Across many tech-heavy cities and suburbs, biotechnology is sparking the uptick in demand. East Baltimore Development, for example, is a nonprofit agency managing the $800 million revitalization of an 80-acre section of the city. In December, EBD named a partnership, including Cleveland’s Forest City Enterprises, a publicly traded real estate company, to develop the first phase -- 30 acres -- of a new project adjacent to the Johns Hopkins University medical campus. The development, valued at about $500 million, will include up to 1.1 million square feet of life sciences and office space.

Looking to capitalize on the growth of the life sciences sector and also a buoyant market for REIT IPOs, San Diego’s BioMed Realty Trust went public in August with a $429 million IPO. BioMed has 32 buildings totaling more than 2.5 million square feet; among its post-IPO acquisitions were the 77,225-square-foot Guilford Pharmaceuticals R&D facility in Baltimore and a 134,989-square-foot building in Seattle occupied by such tenants as Chiron Corp. and Cell Therapeutics.

Just months after the BioMed IPO, a more mainstream tech-related REIT IPO hit the market when Digital Realty Trust, in Menlo Park, California, went public in October in a $257 million debut. Its 23 properties, mostly data centers and Web-hosting facilities, total about 5.6 million square feet. The IPO essentially took public a portfolio owned by private investment fund Global Innovation Partners, a joint venture of CalPERS and CB Richard Ellis Investors.

The lasting strength of the tech real estate recovery, however, will depend on the prospects of the tech industry itself. “What we have to worry about as national investors is, How is this industry doing?” points out Esrig of J.P. Morgan Fleming. “Is it growing at the explosive pace that some of these markets need it to grow at to take down some of this space? I don’t think it is.”

Others are more optimistic. “The nature of technology seems to be that recoveries don’t follow a linear path, because of the pace of change in technology and how quickly things can move there,” says Prudential’s Smith. “The market is beginning to show sufficient signs of having bottomed out. So we’re looking at getting ourselves positioned to take advantage of the recovery. You don’t want to wait until the cow is out of the barn.” Especially if it’s a cash cow.

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