Office Market Taps the Brakes in Q1

The US office market showed signs of fatigue in the first quarter of 2017. Vacancy was unchanged, rent growth slowed, deliveries were fl at and net absorption, while still positive, declined substantially. Sublease inventory also moved higher. Altogether, it has experts wondering whether the long steady recovery in the office sector is showing signs of fatigue. Major markets including New York City, Los Angeles and even tech-darling San Francisco posted significant negative net absorption in Q1, as did Atlanta, Houston and Hartford. 

 Taking a closer look at net absorption, which is the key indicator of market expansion, the first quarter total of 10.8 million square feet was a bit of a surprise. In Q4, over 23 million square feet of net gain was recorded, after gains of 37 million and 36 million square feet in the previous two quarters. In fact, more than 40 markets tracked by CoStar posted net losses in occupied space for the quarter. It is too early to say what long term significance poor absorption for the quarter has, but multiple quarters of declining market growth is worth noting. Downsizing caused by changes in workplace design may be partly to blame for the reduction in net absorption. No sector is immune from the trend in open space design precipitated by demographic shifts in the workforce and the leveraging of advances in mobile technology.

 Only four markets posted net absorption in excess of 1 million square feet. Leading the way was Washington, DC at 2.75 million square feet, followed by Chicago at 2.5 million square feet, Dallas/Ft. Worth at 1.5 million square feet and Boston at 1.1 million square feet. Major market posting disappointing Q1 results included New York City at negative 1.6 million square feet, Los Angeles at negative 1.3 million square feet and Hartford at negative 803,000 square feet. By building class, net absorption remains relatively well-balanced, as Class A, B product reported gains of 5.9 million and 5 million square feet respectively. In terms of Suburban versus Central Business District (CBD) performance, the difference is stark. Absorption 1.25 million square feet to the negative in CBD markets and 12 million square feet to the positive for Suburban markets. It’s the suburban submarkets featuring urbanized hubs that appeal to employers most, as they choose locations that will attract and retain workers who are increasingly in to the live, work and play lifestyle. Millennials are redefining the workforce by way of their strong lifestyle preferences, and landlords who don’t or can’t respond accordingly are being caught out. 

The vacancy rate, which stood at 9.7% as Q1 ended, was unchanged for the second consecutive period, but it is down 20 basis points in the last four quarters. By building class, it is a story of opposites. Vacancy for Class A is up 20 basis points over the past four quarters, while Class B vacancy has declined in each of the last four periods to end Q1 at 9.7%. Suburban and CBD vacancy is just 10 basis points apart at 9.7% and 9.8%, respectively.

 Average asking lease rates for the US moved up again in Q1, adding another $.13 to $24.44 per square foot. That is a .5% increase for the period. Asking rents keep 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. Office occupiers across all sectors are finding new ways to leverage advances in communication and computing technologies in order to use less space. Markets with more active tech and healthcare sectors tend to see bigger rent gains, but energy markets are still seeing rent declines and bigger concessions, mainly to due to large blocks of long term sublease space that compete with direct space offerings.

 The level of new deliveries has been within 1 million square feet for the past four quarters. In Q1, 21.3 million square feet of new office space was delivered, compared to 20.3 million square feet in Q4 of 2016, 20.9 million square feet in Q3 and 20.1 million square feet in Q2. This has allowed the market to expand with minimal risk of overbuilding. The quarter ended with another 154.4 million square feet of space under construction, with most of that total concentrated in the nation’s ten largest markets. New York City is at the top of that list with over 15.75 million square feet underway. Dallas/Fort Worth is not far behind at 11.9 million square feet, followed by Washington DC at 11 million square feet, South Bay/San Jose (Silicon Valley) at 9.9 million square feet and San Francisco at 8.1 million square feet. Another tech-heavy market, Seattle/Puget Sound, rounds out the top five at just under 8 million square feet. The largest project underway in Q1 is still 3 World Trade Center, a 2.86-million-square-foot tower in Manhattan. That building is set for delivery in the first quarter of 2018 and is 37% preleased. Five of the six largest projects currently under construction in the US are located in Manhattan. 

 Developers to focus on mixed-use projects in urbanized, amenity-rich areas that will bring the highest rents. Land and construction costs have been steadily rising and the entitlement process is more expensive and takes longer to navigate through. Lenders are tightening up on underwriting and preleasing requirements make purely speculative projects harder to make happen. Unlike their industrial counterparts who can rely on the e-commerce and 3PL sectors to keep expanding in large space increments, office builders don’t have a particular user type to count on to gobble up large blocks of space. 

 Institutional and private investors still have good quality office buildings at the top of their wish lists. That, and the appetite of foreign capital for US office property assets, has driven cap rates to historical lows. However, as a tighter monetary policy matures, yields in other asset classes should rise. A 50 basis point rise in the going-in cap rate in a 5%-cap world really moves the value needle and that is weighing heavier on the minds of prudent investors. If rent growth slows as it has in some markets across the country, the loss in property values could be substantial. Foreign buyers are the wild card, as their motivation lean toward capital preservation over yield.

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