For most office building owners, a lease running down to less than five years sets off alarm bells. For investors in Europe like Blackstone LP and Carlyle Group LP, it sounds more like cash registers.
Offices with few defects beyond their tenants’ plans to leave are being valued much lower than similar buildings with long-term leases as banks and buyers shun European assets that aren’t considered prime. The gap is attracting cash-rich investors with the chance to lift values by as much as a third by convincing occupants to stick around.
“Any asset that doesn’t tick every single box is basically being mispriced into the secondary market, which is complete nonsense,” said Joe Valente, head of research and strategy at JPMorgan Asset Management. Values are dropping because of “minor defects like a little vacancy or a lease on the cusp of what is deemed acceptable,” Valente and Peter Reilly, head of JPMorgan Asset Management’s European real estate unit, wrote in a February report.
Offices and other income-producing properties with 16 to 25 years on their leases are worth a third more than similar buildings with fewer than five years to run, research firm Investment Property Databank Ltd. estimates. Prime values in the U.K. have climbed 24 percent from a June 2009 low point, while second-tier assets have gained 3 percent, according to data compiled by IPD and broker DTZ.
So-called opportunity funds like Blackstone, which target annual returns of at least 15 percent, bought about an eighth of all income-producing real estate sold in Europe last year, double the average for the previous five years, JPMorgan & Chase Co. said in the February report.
Blackstone paid about 330 million pounds ($504 million) to gain control of Devonshire Square near London’s Liverpool Street station in July after insurance broker Aon Corp., the largest tenant, said it planned to move out. The world’s biggest buyout firm said it will seek technology and media tenants for the space. The building was valued at 413 million pounds in 2006.
“We’ve been active in Europe in distress and short-term leases are a part of that,” Ken Caplan, Blackstone’s senior managing director for European real estate, said in an interview.
The firm is also buying the Adelphi Building near London’s Trafalgar Square for about 260 million pounds, compared with a 2007 valuation of 325 million pounds. The previous owner, a unit of Istithmar Building LLC, failed to repay the loan for the property’s 2006 purchase when it matured in October 2011, according to a stock-exchange filing at the time.
“You’ve 50 percent of the building with a near-term lease expiry this summer,” Caplan said. “The combination of the distress around the debt and the upcoming vacancy in the building created an opportunity for us to purchase this at a big discount to where the past owner had bought it.”
Blackstone followed a similar strategy when it paid 480 million pounds for Chiswick Park, a west London office development, in 2011. The firm extended existing leases and replaced some of the tenants, Caplan said. As a result, average rents have increased 45 percent to about 45 pounds a square foot since the purchase, he said.
TIAA-CREF, the manager of retirement accounts for employees of non-profit institutions, sold two office buildings at London’s Canary Wharf district this year for half the $381 million it paid for them in 2005 after the largest tenant in one property, European Medicines Agency, decided to move out when its lease expires next year. Abby Cohen, a spokeswoman for the New York-based firm, declined to comment.
Citypoint, a 36-story office tower in the City of London financial district, would sell for about 491.7 million pounds if it was put on the market in 2014, broker Knight Frank LP said last year in its most recent published valuation. That would drop by 25 percent by 2017 if the current tenants can’t be persuaded to extend their leases, it said.
“Typically, it’s the seller that has to buckle, particularly for the short-lease stuff,” Valad Europe Plc Chief Executive Officer Martyn McCarthy said in an interview. “There are only a few people who can do those transactions: buyers that don’t need debt or those that have a track record where they’re not equity-rich, but bankers think they’re brilliant.”
Valad, owned by its management and a fund run by Blackstone, isn’t among those buyers, he said. Instead, it’s targeting office buildings in London with leases of five to 10 years. Convincing tenants to extend their stay to more than a decade will produce returns of 15 percent to 20 percent, he said.
Investors are taking advantage of the buying opportunity as banks reduce real estate debt to repair balance sheets hit by property loans that soured in the financial crisis. In London, the prospect of losing tenants as their leases end may have lessened as a lack of development finance limits the amount of new buildings available.
“We’re quite interested in prime location, short-term income where there’s an asset-management play,” Robert Hodges, head of European asset management at Carlyle, said in an interview. Besides London, cities including Paris and Milan and parts of Germany “are areas where cautiously we can go out and do deals.”
The three main types of opportunity funds, including those interested in investing in short-lease properties, are private equity groups like Blackstone, defaulted loan-portfolio purchasers such as Cerberus Capital Management LP and Lone Star Funds, and asset managers like JPMorgan, Valente said.
Some landlords are lifting values by seeking new tenants for properties they own rather than extending existing leases.
Axa Real Estate, the property unit of Europe’s second-largest insurer, bought out a short-term lease for 60 percent of an office building in the Paris suburb of Saint Denis and brought in a new tenant for the entire property.
“That transformed it from a risky asset to a bond-type transaction,” Chief Executive Officer Pierre Vaquier said in an interview. “That’s the kind of game you can play if you have an understanding of the market, the access and the asset-management skills to do it.” Axa Real Estate is seeking to buy short-lease properties in London, he said.
Great Portland Estates Plc., the developer focused on London’s West End district, bought a 50 percent stake this month in an office building at 148 Old Street that is leased to Royal Mail Group Plc. The company could realize a 28 percent profit on its investment if the postal service exercises its option to vacate the building in 2015 and the property is refurbished and rented to technology and media companies, Espirito Santo Investment Bank wrote in an April 3 note.
Europe’s shaky economies are the main risk for investors buying short-lease buildings, Vaquier said. “We don’t have a lot of visibility on the economy over the next two to three years, so the question is: if you have a vacancy during that period, what will happen with those assets?” he said.
Investors also need to be careful about what districts they choose, Development Securities Plc Chief Executive Officer Michael Marx said in an interview. Marx said he’s “still unenthusiastic about rental prospects” in the City of London because of the amount of unoccupied space.
Changing a building in London’s main financial district to make it more suitable for technology, media and telecommunications tenants is also a risk because such companies typically pay less than banks and insurers, he said. Tech firms “don’t need to pay fancy rents; they need warehouses to put people in.”
When considering a lease extension, tenants care most about heating, air conditioning, working elevators and whether the building looks good, Valad’s McCarthy said. “Within three meetings, you can pretty much work out a deal, but you definitely know after the first meeting whether your tenant will stay or go. It’s just subject to the economics,” he said.
Other types of real estate are also creating opportunities as leases run down. Prologis Inc., the world’s largest warehouse owner, has allowed the average lease length in its European properties to shorten to just over three years because it wants to be in a position to benefit from rising rents in under-supplied markets, Philip Dunne, the company’s president for Europe, said in a March interview.
Dunne said he expects the outsized profits from buying short-lease properties to fade as the real estate market becomes more stable.
“We all ran for the hills” after the financial crisis, he said at a seminar last month at the MIPIM property conference in Cannes. “It will settle down again and three- to five-year income in a core market is perfectly fine and will get priced accordingly.”