With the recent spike in interest rates and continued slide in occupancies and rents, it's no wonder that office property valuations are taking a hit. Case in point: In downtown Minneapolis, the International Centre and Kinnard Financial Center reverted back to the lender in late August. The two adjoining towers, which total 610,000 sq. ft., were owned by a partnership of Chicago-based Zeller Realty Corp. and ING Realty Partners.

Although some distressed properties are beginning to emerge, investors are not yet finding a bevy of bargains up for sale. Quality properties are still selling for a premium, a trend that has held firm throughout this choppy economic recovery. Meanwhile, owners of struggling properties are opting to ride out the storm rather than put properties on the market at a discount.

From an investor's point of view, the gap in both value and pricing is widening between premium buildings in core markets and lower-quality buildings in secondary markets. “If a building is going to be exposed to those weak fundamentals, investors are underwriting it conservatively. But if you have a well-leased building, investors will be very aggressively pursuing it,” says James Hanson, managing director of the capital markets group for Jones Lang LaSalle in Chicago.

It is those marginal buildings that are creating a drag on values. Office-building values declined 2.3% from first-quarter levels, according to a survey of buildings in the top 50 markets prepared by New York-based Reis Inc. The survey put second-quarter office values at an average $137.09 per sq. ft., compared with $140.32 in the first quarter. The findings are based upon 10-year forecasted discounted cash flows at individual buildings surveyed.

“Clearly, there is a loss of value because the drop-off in fundamentals has been extreme,” says Alan Pontius, national director of the office and industrial properties group for Encino, Calif.-based Marcus & Millichap Real Estate Investment Brokerage Co.

National office vacancies rose to an average of 16.5% in the second quarter, up from 15.3% a year earlier, according to Reis. Asking rents averaged $25, down 4.6% from a year ago, and effective rents dropped 6.5% to $21.03.

Yet despite those weak fundamentals, sale prices are not taking a corresponding tumble. In fact, a number of transactions are actually posting prices per square foot that are higher compared with sales a year ago. In Chicago, for example, the median price per sq. ft. rose 13.2% during the first half of 2003 to $120.14 per sq. ft., compared with $106.12 in 2002, according to Marcus & Millichap. In downtown Chicago, 225 W. Wacker recently sold for $145 million, or $226 per sq. ft.

CBD properties in general continue to attract top dollar. Real Capital Analytics, New York, tracked $7.5 billion in CBD office transactions in the first half of 2003. Deal volume increased 13% compared with the first half of 2002, while pricing rose 7% to $190 per sq. ft., compared with $178 during the first half of 2002.

Suburban office transactions, on the other hand, do show some signs of softening. The volume of suburban office property sales dropped 2% at mid-year to $9.3 billion. At the same time, pricing dipped to $123 per sq. ft., a 14% drop from the $143 per sq. ft. during the first half of 2002, reports Real Capital Analytics.

Because owners are hanging on to those marginal properties, deal velocity is expected to slow in the coming months. Pontius of Marcus & Millichap expects total transaction volume to decline about 5% in 2003. The historically low interest rates have enabled many landlords to hold properties despite lower cash flow.

“A lot of marginal buildings are not trading today,” Pontius says, “because the owner doesn't want to contend with the discounting.”