ANOTHER WIN FOR THE OFFICE MARKET
After a lackluster start to the year, the US office market surged in Q2, and followed up with another strong showing in Q3. Vacancy continued to decline, rents kept moving higher and net absorption remained well into positive territory. New deliveries maintained momentum, as well. In many ways, the second and third quarter numbers are mirror images of one another. On the other hand, a handful of other hub markets for the tech industry like San Francisco, Seattle and Raleigh/Durham made big gains in Q1. The similarities are most evident in the absorption numbers. In Q3, a gain in occupied space of 36,110,000 square feet was realized, a scant 20,000 square foot difference from Q2’s total. That is more than double Q1’s total and back in
line with the 38 million square feet of net gains tallied in Q4 of last year. This clearly indicates the ongoing demand for office space nationwide. Of note, however, is the fact that two of the country’s largest office markets, New York City and Chicago, have each posted close to 1 million square feet of negative net absorption this year. Almost every other primary and secondary market coast-to-coast, has experienced net gains in occupied space. Market leaders in absorption include Boston at 3.9 million square feet, Seattle/Puget Sound at 3.5 million square feet, Dallas/Fort Worth at 3.4 million square feet, Greater Los Angeles at 3.3 million square feet and Detroit at 3 million square feet. Even Houston, has positively absorbed space year-to-date, but momentum there is still declining due to the ongoing energy sector slowdown. Massive amounts of sublease space pouring onto the market in the nation’s energy capitol are certain to impact market performance there going forward. The San Francisco/Silicon Valley market, superheated over the past several years due to tech sector job growth, may finally be cooling off as job gains moderate and low vacancy limits absorption gains. By building class, net absorption remains in balance, as Class A, B and C product all reported strong Q3 and year-to-date gains.
In terms of Suburban versus CBD performance, over 90% of the Q3 net absorption was recorded in the suburbs. However, many suburban submarkets around the country are developing urban hubs that are attracting a growing number of employers who are intent on being close to millennial workers who prefer higher density areas because it allows them to live, work and play within walking distance.
Average asking lease rates for the US moved sharply higher in Q3, up $.40 to $23.97 per square foot. That is a 1.7% increase in just three months. Rents are moving up in most office markets around the country, but there are significant differences in the trajectory of rent growth within local markets as tenants move between building classes and submarkets to realize operational efficiencies. The quest to do more with less is ongoing. Tenants across all sectors are looking for ways to leverage advances in communication and computing technologies to occupy less space. If space is going to keep getting more expensive, savvy business owners and CEO’s are sure to continue looking for ways to shrink their facilities footprints. Markets with more active tech and healthcare sectors tend to see bigger rent gains. Energy markets are finally seeing rent declines. The looming problem there is the large blocks of space that have been coming back on the market for sublease. That pressure on rents and net absorption, is likely to persist until the slack in demand caused by under-utilization tightens back up.
The level of new deliveries remained steady in Q3 at just over 20.1 million square feet in 424 new buildings, after the delivery of 19.4 million square feet in Q2. The amount of space under construction rose by 5 million square feet in Q3. The quarter ended with 147.5 million square feet of space in the construction pipeline, with more than half of that total concentrated in the nation’s ten largest markets. New York City is at the top of that list with nearly 13.5 million square feet underway. Dallas/Fort Worth is not far behind at 11.8 million square feet, followed by Washington DC at 10.7 million square feet and South Bay/San Jose (Silicon Valley) at 10.1 million square feet. Another tech-heavy market, Seattle/Puget Sound, rounds out the top five at 8 million square feet. The largest project underway in Q3 was the 3 World Trade Center tower in Manhattan. That building is set for delivery in early 2018. Developers continue to focus on mixed-use projects in urban core areas that are near public transit and entertainment venues, which are high priorities for millennials. However, high land prices, rising construction costs and more cautious loan underwriting is keeping speculative development in check, which limits the risk of overbuilding.
Institutions and private investors, both large and small, have been chasing short supply of office product for sale. Cap rates remain compressed to record lows and core assets are trading hands below 5%. Although there are signs of a change in market trajectory, and investors are well-advised to increase efforts to underwrite local market metrics before paying the current premium. Some markets may be peaking in terms of rent growth and if cap rates begin to move higher, that combination poses significant risk, as the rise in cap rates may not be mitigated by growth in net operating income.
Foreign buyers keep pouring capital into US assets in their ongoing efforts to protect capital that they see as being at greater risk around the world. Investors everywhere still see the US as the safest of safe havens to stash capital as prospects for global economic growth becomes more uncertain.
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