Office Market Recovery Accelerating
While Rent Growth Remains Slow, Solid Demand and Muted Construction Point To Future Landlord Market.
U.S. office occupancy growth and rental rates rose at a modest but steady pace during the second quarter of this year, while the national vacancy rate dipped closer to the 12% mark as new office construction remained at historically low levels in the first half of 2013.
“The office market recovery is accelerating. Although it feels like we’re just going from 20 to 25 mph, it is headed in the right direction,” noted Hans Nordby, managing director, who presented CoStar’s State of the U.S. Office Market Mid-Year 2013 Review and Forecast, along with Director of Office Research Walter Page and Manager of U.S. Market Research Aaron Jodka.
The office review and outlook marks the launch of the latest round of CoStar market presentations
Through June 30, 2013, net absorption of office space across the U.S. rose 25% over the same period last year, to 25 million square feet. CoStar’s analysts noted that office absorption is still being tempered by the overhang of tenant shadow space left over from the recession, and by the trend toward open but higher density workspaces, with many new leases averaging less square footage per employee.
Nevertheless, the U.S. office vacancy rate continued to decline, dipping from 12.7% at mid-year 2012 to 12.1% as of June 30, 2013, moving steadily toward the 10.5% – 11% vacancy range that analysts would expect in a balanced office market.
While rent growth has begun to ramp up, average office rents increased by 2% in the first six months of the year, compared with 1.7% in the first six months of last year.
However, the headline number doesn’t tell the whole rent growth story, CoStar’s Page said. “We’re seeing an increasing reduction in [landlord] concessions for free rent across many markets – especially those that offered the most free rent, such as Atlanta,” he said.
One wild card for the office market is the recent uptick in 10-Year Treasurys after years of historically low interest rates propped up by the Federal Reserve’s quantitative easing programs. While CoStar and PPR economists have been forecasting for months that quantitative easing will eventually end, the big story of the past 60 days in the capital markets has been the 70-basis-point rise in the 10-year rate.
While the obvious question is how capitalization rates will react to the rise in interest rates, spreads between marketplace cap rates and Treasurys are fairly wide versus what would be expected at this point in the recovery cycle, Nordby said.
“The good news is that cap rates didn’t follow interest rates all the way down on a one-for-one basis, and they don’t have to go one for one on the way up,” he said.
Moreover, corporate profits remain high, enhancing the ability of companies to hire workers and lease space. Office-using employment growth continues to outperform the broader job market.
Big gains were seen in secondary metro areas in the South and West, such as Jacksonville, FL, Salt Lake City, Nashville, Austin and Denver, where office employment is growing very quickly, bolstered by growth in general back office operations and migration and expansion of companies to markets with lower business costs.
Even Atlanta, which was devastated by the recession and a lackluster performer in the early stages of recovery, now ranks among the nation’s job growth leaders. Interestingly, Atlanta’s growth in tech sector jobs is now above the national average after many years of falling below the U.S. average.
Supply Growth: ‘Moral Equivalent of Zero’
Contributing to the decline in office vacancy is the very low level of new construction and ongoing lack of net new supply. Factoring in demolitions of obsolete office space and other loss of office inventory and net office completions penciled out to just 5 million square feet across the country, or 0.06% of U.S office inventory.
Spec office construction has been virtually nil in most markets, with most of the construction activity comprised of custom-ordered build-to-suit projects, which don’t necessarily compete directly with multi-tenant office buildings.
Office space under construction totaled 65 million square feet at mid-year 2013 – just 0.08% of total inventory – little changed from the 60 million square feet that was under construction in the first six months of 2012.
Most markets report construction levels that are well below their historical average, Jodka said. However, supply is ramping up in Houston, San Francisco, Boston, New York, Washington, D.C. — and in Pittsburgh, a boom center for the emerging shale oil industry, which some observers have pegged as one of the hottest office markets in the country, and has now cracked the top 5 in new supply.
One clue that developers may be readying more office space on the horizon is pre-leasing rates prior to hard construction. In the last year of the boom in 2007, projects were 37% preleased at the start of construction. The rate quickly spiked to nearly 60% during the recession but is now back down to around 40%, and falling.
Pure spec construction with 10% or less space committed to tenants at groundbreaking is still a fraction of 2006-08 levels, but some speculation is cautiously starting to emerge in selected markets.
Vacancy Rate: Room for Improvement
CoStar forecasts that the 12.1% vacancy rate will decline to the 11% range by 2016, a rate of decline of about 10 basis points per quarter. Net absorption will outstrip deliveries throughout the forecast, which should tip the balance from primarily a tenant market to a landlord market, bringing rising rental rates and NOIs.
One indicator is the number of individual metros where vacancies are falling below 12%. In another key indicator of the breadth of the office recovery, about 61% of U.S. submarkets are now seeing vacancy rate declines, a very strong indication that local markets are improving, Page said.
Of some concern is that roughly half of the vacancy declines stem from the removal of space through demolition or conversion of office space to other uses such as residential, rather than tenants leasing and occupying space. Nationwide, about 80 million square feet has been removed from inventory, the equivalent of slightly less than the Chicago CBD office inventory.
About half is being removed for residential uses, particularly in urban infill areas like New York, D.C. and Boston, Page said.
One stubborn holdover from the past era of negative landlord sentiment is the wide spread between the vacancy rate and the availability rate. The 3.9% gap between direct vacancies and availabilities — spaces marketed by owners ahead of lease expirations because they’re not confident the tenant will renew — has remained roughly the same since about 2010.
“In terms of the office market overall, we believe the recovery is about halfway complete,” Page said. “Office is a late recovery play, and we can now say the office market has more upside than any other property type.”
Robust Rent Growth Remains Elusive
While year-over-year occupancy is up in all but two metros (Washington D.C. and Los Angeles), rent growth remained a modest 2% in the first half of 2013. San Francisco’s booming office market remains the major exception, posting phenomenal 10.7% rent growth.
Meanwhile, office net operating income for building owners is expected to benefit as leases signed from 2008 through 2010 expire and are replaced by new leases signed at the current higher rents.
“Leases are starting to turn and there is light at the end of the tunnel. Investors who have held on this long will start to experience some NOI growth, assuming their property has maintained a decent level of occupancy,” Page said.
Source: CoStar Randyl Drummer July 24, 2013