Repriced And Ripe: Institutional Buyers Eyeing Trophy Office

Artificial intelligence is driving a wave of office leasing in a select few cities on both coasts, and investors are trying to follow closely behind.

A growing group of institutional buyers is zeroing in on the top office towers that have recently been magnets for AI and tech demand. They're betting that the current outsized demand for gleaming spaces is here to stay and building strategies around the buildings that are most likely to keep their pricing power after the dust from AI dislocation settles.

“Office is repriced more than any other sector, and so that discount relative to past values is reason enough to reexamine the sector,” said Daniel Vickerman, head of commercial investment research at Heitman, which has $47B in assets under management and is shopping for office assets mostly in the Sun Belt.

It’s far from a roaring recovery, and these institutional buyers are still in the window shopping phase. But they have begun jockeying to buy the best properties in the best markets as it becomes clearer which buildings have staying power. 

“We are most importantly quality-focused,” Vickerman said. “There are concerns about AI's impact on making the office obsolete. We want to avoid that by skating where the puck is going, and that's the trophy segment.” 

The slow, deliberative approach to choosing which assets to bet on and the focus on the highest-quality properties come after a period of painful fallout for office investors. Heavy losses sustained after the pandemic sapped office values have the largest players looking for a long time before they leap.

Commercial real estate capital markets opened the year with momentum building, with U.S. office investment up 61%, according to JLL.

But velocity has been snagged by the impacts of the war with Iran, which helped push inflation to a three-year high and shifted macroeconomic forecasts, and deal volume failed to match last year’s totals in both April and May, according to MSCI data. 

These broader macroeconomic shifts helped weigh on office sales in May, which totaled just $4.1B, down 46% from the prior year. Still, activity is up roughly 44% over the last 12 months.

Despite turbulence for the broader office market, Newmark recently updated its forecast for commercial real estate and flagged trophy office buildings among the sectors with the strongest outlooks. PGIM took a similar view in its midyear report published this month, which highlighted modern offices as the top sector for momentum-based investment. 

Opportunities will revolve around buying new product to take advantage of the upswing in demand, or making value-add investments and upgrading the properties to compete with the few towers absorbing the vast majority of activity in most markets, PGIM’s analysts wrote. 

It’s in some ways a bet on a continuation of the K-shaped economy that is currently defining U.S. macroeconomics, with growth coming from a small group of high earners while the average American is squeezed by rising costs. 

Chicago-based Heitman has been sizing up assets across the U.S. — Vickerman said he’s looked at more office deals in the last six months than the past six years — as it explores the acquisition of a performing asset. 

While focused on the Sun Belt, Vickerman also has eyes on seven neighborhoods in Manhattan, a tech-leasing hot spot along with San Francisco where the explosion in AI-related demand has pushed office prices out of feasible underwriting territory for the asset manager. 

“There might be some groups that are leaning into AI in San Francisco, for example, that may be bidding up property to an unattractive point. New York might be another place where property values have gotten a little inflated relative to where we'd like to see them,” Vickerman said. 

These groups tend to be smaller players that have jumped more quickly back into AI company-approved cities.

Private equity manager Meadow Partners paid $312M for a 37-story office tower in Midtown Manhattan this month that last traded for $252M in 2012. Zara founder Amancio Ortega is in talks to pay more than $500M for an office building backed by a CMBS loan worth $353M at 1 N. Wacker Drive in Chicago. 

Invesco and SteelWave LLC listed defense contractor Anduril’s 634K SF California headquarters for sale last week, looking for a deal worth around $400M as the landlords capitalize on rising interest in the booming tech defense sector, Bloomberg reported.

Nationally, one-fifth of office space was vacant at the end of the first quarter. Space is being removed from inventory through conversions, and new construction is at a 14-year low, but that’s being counterbalanced by the shift in how office space is utilized and the adoption of AI. On balance, occupancy rates are expected to remain relatively flat in the near term.

But the headline figures disguise a reality for well-heeled firms looking for office space: Trophy buildings are filling up in the corners of specific markets where the tech tenants that are driving leasing activity today are clustering. 

The next wave of economic growth is expected to come from productivity gains as opposed to widening the service funnel with larger headcounts, and buyers at the top of the market are following the trend to its natural conclusion by looking at the best properties in the best locations, said Joe Biasi, the head of commercial capital markets research at Newmark.

“When you look at what might benefit and what might struggle, the higher-quality space begins to look a lot more attractive because the firms that are becoming richer but don't necessarily need as much space are going to be willing to pay more dollars per square foot,” Biasi said. 

Erin Patterson, the global co-head of research and strategy at Manulife, is looking back at the last decade of the retail sector’s performance for guidance on where office space is headed.

Retail was confronted by the one-two combo of the rise of e-commerce followed by the pandemic, but the sector has remained resilient throughout and is one of the better-performing in the public market this year.

The office sector’s first hit was the pandemic, and it's now confronting the rise of AI, which has created opportunities for savvy investors that can get deep into the financial picture and rent roll of an asset to identify strong deals.

“If we saw a good opportunity, we wouldn't say no to it,” Patterson said. “You have to be sensible about how your tenancy would or would not be affected by AI. We look at all of those pieces, and I think that's the sentiment of many.”

While institutional players are chasing the best-of-the-best, value-add players are trickling in with strategies to buy into Class-A properties in tight markets that can reach trophy status with upgrades, CoStar National Director of Office Analytics Phil Mobley said in an email. 

Sales are concentrated in New York and San Francisco, where the explosion in office leasing demand is already seeping into the tier just below trophy towers but also in small pockets of other cities like Chicago, Miami and Phoenix.

“Investors have a better sense of which ‘commodity Class-A’ buildings can be truly competitive and of the level of capital investment required to get them there,” Mobley said.

There’s some debate about how far the leasing boom will travel. Top firms tend to try to lease space near other top firms, and that’s especially true of AI and tech tenants, Biasi said.

Location matters as much as quality, and the trophy properties with subpar locations could face the same lease-up struggles as their cheaper counterparts. Large corporations previously expanded into suburban markets for back-office staff in part because the space and salaries were cheaper. 

AI is expected to increase productivity and automate work done by those employees in the suburbs. As firms roll out AI solutions that cut headcount, those offices will become increasingly obsolete.

With AI diminishing the need for administrative staff, the most beautiful office building might still struggle to attract tenants if it is outside where top firms have clustered, Biasi said.  

“It's literally top-down where the top floors are seen more than the bottom floors, but it’s also top-down in concentrated locations and it goes out,” Biasi said. “When you have slower demographic growth, you would expect that growth to maybe not go as far out.”