Office Market Keeps Pace, But Energy States Begin to Feel the Pinch

The Lee Office Brief Q2 2015

 National Market Overview

The US office market has recorded another vacancy decline of 10 basis points to 10.8%. However, most of the activity is concentrated in a handful of major markets, secondary markets make more modest gains. In the past four quarters, the overall vacancy rate has moved down by 30 basis points, and with so much of the activity concentrated in larger spaces, larger blocks of space are becoming harder to find in hot markets like San Francisco and New York and where growth in the TAMI sector has boosted job creation and sent rents to record highs.

New deliveries were little changed over Q1, down slightly to 16.9 million square feet in 249 buildings. The country’s existing base of office space now stands at 10.55 billion square feet. In the past four quarters, over 67 million square feet of space has been completed, and another 133.5 million square feet was underway by the end of Q2, which has 2015 on pace to surpass 2014 in terms of new inventory.

Central Business Districts in the biggest markets are still where the action is, mostly in mixed-use projects with residential and retail components. Speculative development activity is still strong due to optimistic forecasts for strong rent growth and net absorption, except in selected energy market like Houston that are seeing spec projects put on hold until the energy sector returns to better health.

Secondary markets are seeing more developments, as well, especially those with the lowest vacancy rates. Lenders are still looking for substantial prelease commitments to fund new projects in those areas.

Net absorption for Q1, remained positive at 30.54 million square feet, more than doubling Q1’s total of 14.84 million square feet, but more in line with Q4 of 2014’s total of 37.7 million square feet. Net absorption for this year will remain near 2014 levels, but the reversal of fortune in the energy markets, where growth had been strongest, could hurt the year end totals. Pre-commitments
for large blocks of space in those areas have softened the negative impact of net absorption through 30 the first half of the year. Second half absorption could be a different story, as the slow down
 in energy market activity shows
up on the absorption side of the equation. Class A led the way again in Q2, posting a gain of 16.54 million square feet. Class B added another 11.23 million
 square feet to the total. Users are
increasing employee density with
 more open floor plans and remain willing to pay higher rental rates in return. It is difficult to quantify the exact impact of this phenomenon, but it will become more apparent as the trend continues.

Average asking lease rates for the US moved up another 0.7% in Q1 to $22.91 per square foot. Rent increases were recorded nearly all markets around the US, but bigger markets with concentrations of TAMI (technology, advertising, media and information) and healthcare services firms are faring best. Energy-based markets like Houston are seeing rent growth level off, as near-term demand for space has slowed dramatically and the amount of sublease space has risen as energy tenants try to shed excess capacity. Class A space in downtown areas and urban cores, rich in amenities, are still seeing the strongest rent growth.

Domestic institutions that see substantial rent growth in this up-cycle as likely, compete aggressively for trophy assets in major markets, which has kept cap rates compressed to historic lows. Foreign buyers motivated to safely place their capital in light of shakier economic conditions in other parts of the world, compete directly with US investors at all levels, which has exacerbated the cap rate decline. Secondary markets are now seeing the benefit of the increase in demand, as buyers of all kinds, hungry to acquire product, are looking in more markets to place their capital. Value-add opportunities in markets with well-located older product are gaining in popularity, as well. Repositioning of strategically located, older assets is being undertaken to attract tenants that hire younger workers who like the amenities and convenience of urban areas.

A Look Ahead

The US office market should remain strong through the end of 2015. Overall growth for office-using businesses is broad-based and all the key market metrics signal continued health for the office market for the next several quarters. However, the potential consequences of anticipated actions of the Fed to raise rates and the double-edged sword of lower energy costs could challenge the status quo going forward.

Low oil prices will be with us for the near term and that will give consumers more buying power and lower operating costs for US businesses. But, tougher times are ahead for energy-dependent states that will see lower office leasing activity, slowing of net absorption and a big pullback in new construction until the energy crisis wanes. More layoffs in high-paying energy job categories are likely and the significant slowdown in domestic oil production will continue to put downward pressure on office markets in energy states. Employment gains in other sectors, (even in energy markets) are still accelerating, and that activity should be strong enough to offset job losses in the energy sector. While the lower cost of fossil fuel has its advantages in terms of lower operating costs and more disposable personal income, the effects on the growth of the office market will be noticeable going forward.

Vacancy rates will continue to decline and net absorption will remain at least at current levels. However, absorption and leasing activity slow in some markets due to lack of quality supply. Cap rates will remain compressed due to record high demand, but they could begin to move in the other direction once the Fed makes a move on interest rates. Higher interest rates mean higher yields on alternative investments, which could hurt the equities market and pricier real estate markets in the short term. Office development should remain at current levels for the near term (except in energy markets) with CBD’s and core suburban markets seeing the bulk of that activity.

Click the following link to download The Lee Office Brief Q2 2015

About the Author Michael Staskiewicz

Michael Staskiewicz, CCIM is the Managing Broker/ Senior Vice President of The Garibaldi Group and Founder of Michael helps innovative, purpose-driven CEOs clarify the strategic plan for a world-class work environment, so they can attract the best talent and reduce voluntary turnover.

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