Strong impetus for Class B investments - Supplement: Annual Review and Forecast, section 1

As 1998 unfolds, New York is riding a wave of economic growth that is adding significant impetus to Class B office building investment opportunities.

This is not a new phenomenon. Class B office buildings have over the years gradually moved to the forefront of New York City's real estate market, offering the largest acquisition opportunities and delivering yields that are significantly higher than any other product class. One major reason for this is that Class B buildings tend to be older, so rents are significantly lower than in Class A buildings.

Statistically, Class B buildings rent about $13 less per square foot than A buildings. In other words, there is over a 50 percent premium for Class A buildings. The money tenants can save by renting space in B buildings is a huge incentive. For example, if a 20,000 square-foot tenant saves $13 per square foot, it can put $260,000 per year or nearly $3 million in 10 years directly into its pockets.

Another huge attribute of Class B Manhattan office space is that it is almost always in highly desirable locations and traditionally provides first class facilities. This attracts high quality tenants like Coca Cola, First Boston, Omnicom, NationsBank and K III Communications, all of whom presently occupy distinctive offices in Class B Manhattan buildings.

But there's something else driving the Class B occupancy growth in The Big Apple. According to New York City statistics, private sector employment has increased by 55,000 in the last 12 months. With over 175,000 jobs created since 1993, small companies have been the dominant job generators over the past three years. It's those small companies with under 100 employees that target Class B buildings for first class offices, prime locations, and tremendous savings.

Statistics indicate that vacancies in the B market have declined from over 17 percent in 1992 to 12 percent in 1996. As vacancies are projected to decline to under 10 percent in 1997, rents are expected to spike up even more dramatically. This further drives the market in the direction of Class B buildings, as companies rush to snatch up the rapidly decreasing available space.

Of course, the key question is "With vacancies going down 'and rents going up, should we expect new Class A construction?" The answer is "no," because Manhattan's economy differs vastly from the rest of the country. With the current asking rents of $51 per square foot and the current cost of construction at $358 per square foot based upon land costs and building costs in New York City, rents would have to jump to $55 a square foot to justify new construction. At that rate, there would be a stabilized return of only 10 percent. We predict that there will be hardly any new office construction in New York City until rents jump considerably.

Finally, our experience shows that Class B buildings not only generate higher returns than Class A buildings, but they present significant opportunity for value enhancement. And that's a winning investment formula.

COPYRIGHT 1998 Hagedorn Publication
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