The US office property market has come a long way since it bottomed out in 2010. Led by markets fueled by booms in the energy and technology sectors in the Southwest and West, the market recovery is now broader based and picking up steam. Net absorption for the quarter totaled 27,555,343 square feet, marking the ninth straight quarter of positive growth. Vacancy moved down again as a result. At the end of Q3, just 11.2% of nation’s base of 10.5 billion square feet sat vacant. New deliveries have lagged behind increasing demand, so vacancy is likely to continue its decline across the nation for the foreseeable future. However, the dwindling supply of big blocks of space has developers anxious to bring on new supply they can lease to strong credit tenants willing to commit to long-term contracts.
Until recently, energy markets in Texas and tech markets in California were accounting for a disproportionate share of the good news. That trend is changing because primary and secondary markets throughout the country are posting better job growth numbers as confidence in a sustainable economic expansion grows. Gains in professional and business services, health services along with tech and energy jobs, have helped drive the unemployment rate down to 5.9%, the lowest mark since the middle of 2008. In Q3, monthly job growth ranged from 226,000 to 308,000.
The improving market metrics have investors making aggressive bids to acquire quality office properties. Cap rates remain compressed, with quality projects trading in the 5% range in the hottest markets. Even markets hardest hit by the last recession are garnering significant activity, as investors are increasingly optimistic about rent growth due to strong demand coupled with limited development of new product. Competitive bidding on institutional quality assets is the norm again, and distressed asset sales are in decline.
GDP growth is also on the rise. Q2 GDP expansion came in at a revised 4.6.% after a brutal winter contributed to a disappointing -2.1% in Q1. Preliminary estimates of Q3 growth are coming 25.0 in the 3% range, further evidence of the business 20.0 sector’s willingness to take on additional risk. This is tempered by disappointing wage growth numbers, as a significant chunk of the new jobs being created are lower-skilled and lower-paying, and many of those are offered on a part time basis. It’s the good jobs that drive net absorption. So, even though the economic recovery is broad-based, look for energy and tech heavy markets to continue posting the best numbers over the next several quarters.
Another cause for caution is the potential ramifications of the end of Quantitative Easing, the US Federal Reserve’s unprecedented bond-buying program that added approximately $5 trillion to the central bank’s balance sheet over the last five years. Concerns over QE’s potential impact on bond yields and inflation have the attention of C suite occupiers across the board. Long-term rates for real estate financing will likely rise in response, as most of those loans are indexed to the yield on 10 year US Treasuries. With rising interest rates, comes higher yields on other investments, which could precipitate a pullback in the equities markets, as yield-chasing investors, invested heavily in equities, rebalance portfolios with moves to other asset classes. That could be good news for real estate, as it tends to be less volatile and a good hedge against inflation.
While it is impossible to predict the actual outcome, it is safe to say that the weaning of the economy off Fed stimulus programs will impact decision making for investors and users. As the Fed normalizes its benchmark interest rates, the rise in cost of capital will be worthy of close attention. Even a small paring of growth plans in the business sector could negatively impact the tepid recovery.
The national office properties market will continue to grow over the next several quarters. Net absorption should remain in strong positive territory as the country’s prospects for job growth are getting better. The tech sector, in particular, will continue to expand, adding high-paying jobs along the way. The energy sector will stay on its growth path, as well, offering engineers and construction workers more opportunities for full term work at the higher end of the income spectrum. Professional and business services, along with the healthcare industry, will also add a bigger share of the good-paying jobs. However, concerns over wage growth in lower-skilled jobs will continue to put a drag on economic growth. Federal Reserve policy, the midterm election and military conflicts around the globe will be distractions, but gains in domestic energy production will continue to be a bright spot and will hold down fears of higher energy prices generally seen when upheaval in the Middle East heats up. Something to keep an eye on is cap rate decompression and a possible reduction in business expansion due to a rise in the cost of capital resulting from a tighter Fed policy. Higher costs for development will require steady rent growth. Look for more high-end, mixed use projects in major metro areas as a result. Concerns over health care costs will be back on the front page again, as the Affordable Care Act’s employer mandates are approaching, along with the enrollment window for year two of the controversial law.
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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.