The US office property market continued on a steady course of progress, shaving another 10 basis points off the vacancy rate for the third consecutive quarter. The benchmark rate now stands at 11.4%. While there are several markets outperforming the national average, net absorption and leasing activity is consistently positive across the country in both primary and secondary markets. The national economy is expanding just enough to keep job growth positive and office space users are capturing a disproportionate share of employment gains. Rents are on the rise, as well. The combined rate for all building classes rose slightly in the second quarter to $23.99, up 3.4% year-over-year. However, several markets have seen more rapid rent growth over the past year. San Francisco office rental rates have risen by 12.8% in just four quarters. Houston’s rents are up 6.4% in the same period and Dallas rents are also up by 4.5%.
The national office market posted 24,500,000 square feet of net absorption in the second quarter, well above the 18,000,000 registered in Q1. All building classes picked up the pace in Q2. Class A and class B net absorption was evenly split at 10,000,000 square feet each, but net absorption in suburban markets is out- pacing that of the Central Business Districts. Class C net absorption rebounded to just over 3,500,000, up from just over 1,000,000 in Q1. Overall, net absorption for all office property types is up 35% year-over-year. These numbers are particularly impressive given the fact that many users can still accommodate significant internal growth by “reabsorbing” existing space that was underutilized during the recession. Add the fact that space allocated to each worker is trending down as businesses move toward more open floor plans to ac- commodate the preferences of the millennial generation that now make up over 35% of the workface. These workers are attracted to the new “creative” space design, which promotes communication and collaboration through the use of more common areas for socializing and recreation. Privacy for these workers is less impor- tant than their baby boomer counterparts, largely due to their preference for communicating via text, email and social media.
Construction activity is also up compared to the same period in 2013. 95,000,000 square feet of office property is underway, up a healthy 27% over 2013’s second quarter. Deliveries year-to-date are up by 17% to 21,000,000. It is important to note, however, that over half of the current construction activity is concentrated in just 7 markets, led by Houston at 17,000,000 square feet. Pre-leased space accounts for over 65% of the square footage under construction, which reflects large build-to-suit deals in major markets. However, that number is trending down as healthier market metrics are encouraging more speculative projects.
The sale market is also making significant gains. Cap rates for the highest quality office properties are sub 5%, but the average cap rate for all office property classes nationwide is still in the 7.5% range. Demand for property acquisition in major markets is strong, and competitive bidding for quality assets is becoming more common. In Q2 of 2014, over $52 Billion in office property sales took place, up sharply from $15 Billion in the first quarter.
The office market has certainly come a long way from its low point in 2009, and the current trajectory appears to be sustainable. Now let’s take a closer look at key economic factors and use trends that will influence market performance over the next several quarters:
Gross Domestic Product (GDP) has long been a primary benchmark for assessing economic health. First quarter GDP was negative, but preliminary estimates for Q2 suggest a surge that will put the nation back on course to continue growing the 2% range, which is still substantially less than in previous recoveries. Many blame the depth and breadth of what came to be known as the ‘Great Recession’, which hit all elements of the economy hard, especially the financial sector. While it is true that our overall economy has improved, there remains an element of uncertainty that has kept GDP advancing at a sluggish pace. Consumer spending growth, which accounts for 70% of GDP, has been nominal as consumers focus on reducing debt accumulated during the recession. The bright spot when it comes to economic growth is related to energy production, as advances in methods to free up natural gas and oil are fueling an energy boom. North Dakota, which now boasts the lowest unemployment rate in the nation, has led the way with its Bakken oil field production. Along with generating good-paying jobs, energy production boosts GDP growth by reducing imports, a key component of the GDP formula. Growth in the tech sector is also giving a boost to GDP, which will continue to support strong gains in the office property market.
The current cycle of economic expansion has often been referred to as a “jobless recovery.” The unemployment rate has been slow to fall from its peak of 10% back in 2010. Moreover, much of the reduction in the unemployment rate, which now stands at 6.2%, has come from discouraged job seekers leaving the workforce rather than through the creation of new jobs. This has made the traditional unemployment rate a less reliable indicator of economic health. The Labor Participation Rate, which measures the percentage of the potential workforce engaged in work activity, is a more telling indicator. That index stands at approximately 63%, the lowest it has been in four decades. There has also been a shift to more part time jobs, as employers wary of unknown costs of the Affordable Care Act and it’s affect on the economy, are hiring workers below the law’s 30 hour per week threshold for full time employment. That said, net job growth is becoming more consistent, month-to-month. Good news came in May as revised estimates for new job creation hit 288,000, the best month of 2014, by a large margin. The office market is the prime beneficiary of the improving job picture, as growth in office using jobs is leading the way. Markets with the highest levels of net absorption have rapidly growing tech sectors, San Francisco being a prime example.
In addition, to keeping its benchmark rates near zero for several years now, the Federal Reserve Bank has been engaged in a massive bond buying program meant to increase the flow and decrease the cost of capital throughout the economy. The Fed has added over $4 Trillion to its balance sheet for the program known as Quantitative Easing (QE) with mixed results. Until recently, the central bank was buying back US Treasuries and purchasing Residential Mortgage-Backed Securities (RMBS) at a rate of $85 Billion per month. In December of 2013, the Fed began scaling the program back, reducing monthly purchases by $10 Billion per month. Inflation fears associated with the Fed pullback have not yet materialized. If the program can be up unwound without igniting an inflationary cycle, confidence should increase and office lease and sale activity could accelerate. However, as QE is phased out, mortgage rates are likely to rise, which could put pressure on cap rates to move back up to maintain the spread to the cost of capital.
With the midterm elections just a few months away, it is unlikely that any significant legislation will be enacted this year. Immigration reform, balancing the budget and other big issues will be on the back burner, at least until next year. Current gridlock in Congress due to having opposing parties in control of the Senate and House of Representatives, has Congressional approval ratings at all time lows, and several political scandals within the Executive Branch have captured media headlines in recent months.
Concerns over the poor rollout of the Affordable Care Act and confusion over the potential impact of multiple changes to the law by executive order, has created additional uncertainty over the cost of the controversial health care law. Forward planning for expansion is more difficult as a result, which could negatively affect absorption in the near term.
Federal deficit spending fell in the 2013 fiscal year to $680 Billion, a staggering sum, but down from over $1 Trillion the year before. The narrowing gap can be attributed to the increases in income and capital gains tax rates, mandatory cuts due to Sequestration, the winding down of two wars and other cost cutting measures at the federal level. The national debt, at over $17 Trillion, is still rising with no change in trajectory in sight at the moment. The Affordable Care Act has captured the recent headlines on the entitlement front, but concerns over unfunded liabilities for Social Security, Medicare and Medicaid over the long term are still looming as the Baby Boom generation, the largest in American history, moves into retirement. Attempts by the US House of Representatives to legislate spending cuts are generally considered dead on arrival when they reach the US Senate. When the Fed finally starts raising interest rates, debt service on US Treasuries will increase accordingly, exacerbating the deficit issue. How federal deficits will impact absorption directly is unknown. At minimum, it will add to the uncertainty over other issues facing the office property market.
The office property market should continue to improve through the balance of 2014. Vacancy will continue its steady decline and rental rates will move up accordingly. Net absorption will stay in positive territory, as the economy remains in expansion mode. Markets heavy in energy and technology will be the top performers. Keep a close eye on Houston (energy) and San Francisco (technology), as both those markets are leading the charge in their respective niches.
The generational shift from Baby Boomers to Millennials will continue to influence how space is utilized and could even slow net absorption as companies shift from traditional to more creative space designs. Institutional investors will expand their acquisition criteria to include older properties in gentrifying areas that can be retrofit to satisfy the growing need for creative space alternatives.
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Michael Staskiewicz, CCIM is the Managing Broker/ Senior Vice President of The Garibaldi Group and Founder of EffectiveWorkplace.com. 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.