Office Clusters

Offices cluster like nothing else. Build an office building and you have one office building. Build a second, and you may have enough workers in one place to support a restaurant for lunch. The restaurant makes the neighborhood attractive for a third office building, which brings in restaurant #2 and a day care center, and now the neighborhood is on a roll. It is at critical mass. It is "clustered up."

Clusters
Offices cluster so much that, when they can't go out, they go up. They become skyscrapers. Nothing else does that quite as much. Not retail. Not apartments. Certainly not industrials. Look at the landscape of offices in Greater Boston: a big cluster at the Financial District and smaller clusters in Cambridge and suburban parks within a short drive of where the bosses from the tenant companies live. Between these clusters are broad seas where the only office space is in small buildings that serve a very local population: Milton, Millis, Arlington, Melrose, or Jamaica Plain.

Vulnerability to Vacancy
Office clusters get "the flu" in the form of high vacancy. In 2000, vacancy hit Greater Boston hard. It hit the clusters far harder than it did the sea of small buildings housing the local lawyers and professionals that, in good times and bad, chug along. In two years, REIS reported, vacancy went from 4% to 20%, and until recently it has stayed there. Rents fell just as fast, by 33%. REIS forecasts that vacancy will not drop below 10% in Boston for another five years. In spite of all that, office prices have held steady. TheNational Real Estate Indexreports office prices declining only 4% in Greater Boston since the rent peak five years ago.

Investor Reaction
Under conditions like these, investment in offices would appear to be a risky proposition. A half empty building is likely to be a half empty building for some time. The critical factor that has worked to prop up prices is investors' willingness to accept increasingly lower rates of return.

TheKorpacz Real Estate Investor Surveyreports the low end of the capitalization rate range in the Boston market declining from 8.0% to 6.5% in three years. Korpacz reports the results of a survey of participants, only some of whom are buyers. The buyers, by definition, are the respondents at the low end of the range: they are the ones willing to accept the lowest rates of return and, so, are able to beat the competition and make the deal. The real test for a rate of return is an analysis throughfor a property where cash flows and an actual selling price are available. Analysis with data of this kind indicates rates of return at or below the low end of published surveys.

The strength of the Boston office market is investors' faith in the ability of the region to produce innovations that will grow businesses and require offices. Boston traditionally has done that. When innovation falters, Boston falters. When innovation attracts capital, Boston succeeds. Boston's office clusters are at the "down" end of a cycle. But investors take the long look. REIS cites the recent acquisition of the Bay Colony Corporate Center in Waltham at $275 per square foot, a high price in relation to the center's "depressed" rents. REIS says, "The property was acquired for its long-term potential, given that the Boston office market is poised for a strong recovery." Investors looking at Boston see long-term success.

Eric T. Reenstierna, MAI