Salomon Smith Barney is advising investors that securities backed by conservatively written office-building loans are a good bet, noting a rent surge in recent lease renewals.
"At this stage in the economic cycle, the office market's volatile nature is working to landlords' and investors' benefit," wrote Salomon analyst Darrell Wheeler in a recent report.
The report pointed to a $177 million mortgage originated three years ago by Nomura Asset Capital Corp.
At the time the loan, backed by the Fox Plaza office tower in Los Angeles, was considered a somewhat risky proposition, and terms were set to cushion the lender.
The lease for Twentieth Century Fox, the biggest tenant in the 710,767-square-foot building, was set to expire in 2001. So Nomura required the landlord, an entity controlled by billionaire Marvin Davis, to set aside $5 million in a reserve account and add $1 million to the account every year in case there was trouble re-leasing Fox's 300,000 square feet. And when Nomura included the loan in a commercial-mortgage-backed security in 1998, the rating agencies required it to use high subordination levels.
Last month Fox renewed its lease at a 30% higher rent, and Mr. Davis' group sold the building for $355 million, 37% more than it paid.
"In most instances, tenants have no other locations available and must accept the landlords' unfavorable market terms," Mr. Wheeler said, though cautioning that not every market has performed well and some are overbuilt.
Though demand for office space is sparking construction, Mr. Wheeler wrote, zoning restrictions, limited construction supplies, and lending guidelines that require preleasing will keep development in check.
"Over all, it is unlikely that office rental levels will decrease in the next 24 months," he wrote.
Depending on when the leases rolled over, office buildings that were mortgaged from 1996 through 1998 may have current net operating incomes 30% to 50% higher than when the loans were underwritten, Mr. Wheeler said. And recently originated office mortgages "should benefit from the rental imbalance that continues to develop in many markets."
Real estate investment trusts that concentrate on the office sector are also benefiting. Last week Spieker Properties Inc. of Menlo Park, Calif., reported that it renewed or replaced leases on 2.5 million square feet in the second quarter at rents 68% higher on average.
Nationwide, office rents have increased by 9% a year for the past three years, and vacancy rates have declined each year, according to Torto Wheaton Research, a unit of CB Richard Ellis.
The stellar performance reflects not only a strong economy but also a lack of new construction, the upshot of lenders' refusal to finance speculative development since the early-'90s recession, Mr. Wheeler wrote.
"In cases where speculative office development has taken place, the new supply has usually fallen significantly short of the local market's space demand," he said.
But he emphasized that it is still "prudent" for rating agencies and underwriters to structure office loans with safeguards against lease rollover risk.