Tech and TAMI Fuel Absorption in Major Markets

The Lee Office Brief Q1 2015

 

Trending Now

The US office market kept on its path of recovery in Q1, recording another vacancy decline of 10 basis points to 10.9%. However, a disproportionate amount of the leasing activity occurred in a handful of major markets, while many smaller, secondary markets remained relatively static. In the past four quarters, the overall vacancy rate has moved down by 50 basis points, as big corporate users have been pulling the trigger on expansion plans. As a result, large blocks of space are becoming harder to secure in markets like San Francisco where growth in the tech sector has boosted job creation and sent rents soaring.

New deliveries remained steady for the quarter. Over 16.5 million square feet in 244 buildings were added to the country’s existing base of 10.5 billion square feet. In the past four quarters, over 61 million square feet of space has been completed, and another 115 million square feet was underway by the end of Q1, which will keep 2015 on pace in terms of expanding the country’s stock of office space. Central Business District’s (CBD) in the biggest markets will see the most construction activity, and much of that will be in mixed-use projects with residential and retail components.

While many projects are substantially pre-leased, speculative development activity is on the rise due to optimistic forecasts for strong rent growth and net absorption. Some secondary markets are getting back in development mode, as well, especially those with vacancy declines into single digits. However, cautious developers and their lenders will still look for substantial pre-lease commitments in those markets.

Net absorption for Q1, remained positive at 15.4 million square feet, but fell well short of Q4’s total of 37.5 million square feet. However, seasonal differences may account for some of the shortfall, as Q1 of 2014 saw similarly light gains in occupied space. Most local market experts predict that net absorption for this year will remain near 2014 levels, but supply shortages in some markets could see growth in occupied space moderate until new deliveries pick up the slack. Class A led the way again in Q1, posting a gain of 8.1 million square feet. Class B added another 6 million square feet to the total. Users, looking for the efficiencies gained through higher employee density and communication technologies are stepping up to higher rental rates and controlling occupancy at the same time.

Average asking lease rates for the US moved up another 0.4% in Q1 to $22.74 per square foot. Rent increases were recorded in most primary and secondary markets around the US, with the biggest gains seen where there are concentrations of TAMI (technology, advertising, media and information) and healthcare companies. Energy-based markets like Houston are beginning to see rent growth level off, as near-term demand for space is expected to slow until energy prices stabilize at higher levels. Class A space in downtown areas and urban cores, rich in amenities, are recording the strongest rent gains overall.

Investor interest in office properties continued to increase. Domestic institutions that see substantial rent growth in this up-cycle as likely, compete aggressively for trophy assets in major markets, which has driven cap rates to new lows. Foreign buyers, flush with cash and motivated to place capital in what they believe is the world’s safest economy, are adding to the competitive mix and keeping supply well short of demand. This is good news for better-performing secondary markets, as big investors will acquire product at compressed cap rates there, as well. The appetite to take on more risk is also manifested by the rise in value-add opportunities in markets with well-located older product that can be updated and repositioned to capture tenants who need to attract and retain younger workers.

Economic Drivers

The nation’s total output of goods and services showed significant improvement in 2014. GDP grew at an annual rate approaching 3%, but lower than anticipated due to a disappointing fourth quarter after back-to-back quarters in the 4% to 5% range that had everybody talking about better times ahead. Unfortunately, preliminary estimates for Q1 GDP growth are not optimistic. Another cold winter for most of the country is expected to negatively impact Q1 performance. Bad weather was blamed for a 2.1% decline in the first quarter of last year. With circumstances being so similar, poor Q1 performance will not come as much of a surprise. The Congressional Budget Office recently released its annual economic forecast, and it calls for GDP growth of 3% for the year.

The unemployment rate has been moving down for several years, and is now fluctuating in the mid-five percent range. The national unemployment rate through February remained at 5.5%, but tends to fluctuate by a tenth or two each month, as the impact of new jobs is balanced against the change in the number of unemployed workers rejoining or exiting the work force. Part-time positions remain a problem, and may be giving a false sense of improvement to the economy, as these jobs yield less spendable income to boost GDP. The Labor Participation Rate, which measures the number of people eligible to work compared to those who are gainfully employed, is stuck at 62.7%, lowest in four decades. This is partly due to retiring Baby Boomers, but more importantly, it is indicative of a lack of quality jobs at rates of pay that motivate more participation in the work force. However, recent increases in the number of workers quitting existing jobs indicates greater confidence amongst workers that better positions are on offer.

Job growth picked up the pace in 2014, which showed up in the net absorption gains for the year. Job creation ranged from 200,000 to 300,000 per month in 2014, topping out at 353,000 in November. Then 2015 got off to a strong start. January and February hit 275,000 and 295,000 in new job creation respectively, but March was another story altogether, adding a meager 126,000 jobs for the month. Many didn’t see it coming, and the reasons are not clear, but it is cause for concern, and it will put all eyes on April’s report along with preliminary GDP estimates for the quarter. However, the poor job numbers gave the stock markets a boost, as investor concerns over a near-term move by the Fed to raise rates were softened.

Wage growth is perhaps as much a concern as job growth. Since the last recession, real wage growth has been disappointing, with many of the jobs being created in the unskilled and semi-skilled categories. The increase in the number of part-time jobs is also a drag on wage growth. Without more disposable income, GDP growth will be negatively impacted since consumer spending makes up roughly 70% of GDP. The slowdown in the energy sector is also affecting wage growth, as jobs in that sector tend to be higher paying and full time. Layoffs in energy have become commonplace again, and it will certainly curtail job creation in the energy states. Fortunately, job gains in technology, professional services and the TAMI sector have been strong and are expected to remain so. While these sectors offer more of a benefit to the office market, any net gain in jobs and income helps the economy at all levels.

The equities market has soared for the past five years as result, as it is offers a chance at a reasonable yield without giving up liquidity. Real estate borrowers have also benefited from Fed actions. Long-term financing is still available at historically low rates. Low cost of capital has also contributed to cap rate compression in markets around the country. Positive leverage is still a possibility, even with cap rates as low as 4% for prime properties. But, that is still double the yield of the 10-Year T-Bill, which, in mid-April stood at 1.9%. When treasury yields finally go up as the Fed moves interest rates higher, cap rate decompression to maintain that spread becomes a real possibility. Investors will have to focus on markets where rent growth is strongest to make up the difference. Exit cap rate estimates will have to go up, which will bring IRR’s down accordingly.

Thankfully, quantitative easing (QE) is finally behind us, so now it becomes a question of when the Fed makes a move on interest rates. While many believe that will occur in Q2, others think no rate hike will occur until GDP and core inflation become more predictable.

The global economy is another variable for our central bank to consider before bumping our interest rates. The European Central Bank announced an aggressive QE program just as we ended ours in the US. With growth either at zero or in negative territory in the Eurozone, it may not be a good time for our central bank to make things more difficult domestically. Several central banks in Europe even have moved core rates into negative territory in their attempt to avoid a potential deflationary cycle that would stall out the chances for economic growth in the region.

Changes in currency valuation are also impacting economic growth domestically. The US Dollar has moved to all-time highs against the Yen and the Euro. That means additional buying power when purchasing foreign goods and services with US dollars, but it also has a negative impact on US companies with revenues generated from their customers who pay in other currencies.

Oil prices remain in the $50 per barrel range after plummeting from $107 per barrel in June of 2014. Industry experts are all over the board in terms of predicting an end to the decline. Here again, the good news is also bad news. Lower energy prices have put tens of billions back in the pockets of US consumers, but they have also hurt job growth in energy states and reduced the level of exploration and extraction activities across the country. Excess supply is to blame, and that is due to increased productivity in the US and anemic worldwide economic growth, which has reduced demand for fossil fuel products. OPEC has thus far refused to cut production in response, which many believe is a strategic move to slow US production by pushing prices low enough to make US oil and gas extraction unprofitable. At the moment, that strategy seems to be working.

A Look Ahead

The US office market should remain strong through the end of 2015. Domestic GDP and job growth should be healthy enough to offset a sluggish global economy. The strong dollar and influx of foreign capital make clear the perception that the US economy is once again the strongest and healthiest in the world. The dollar is still the world’s reserve currency and US Treasuries are still considered the safest investment alternative.

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. This will increase consumer spending in the short term and stimulate additional job growth across the country. Energy dependent states will have a rougher time until prices stabilize at much higher levels. Expect more layoffs in high-paying energy job categories and a significant slowdown in domestic production until the price of oil makes sense to extract and refine again. Fortunately, gains in employment, even in the energy states, are broad-based enough to stay in positive territory overall.

Vacancy rates will continue to decline and net absorption will remain at least at current levels. However, markets with the lowest vacancy will see absorption and leasing activity moderate due to lack of 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 means 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 the current pace, with CBD’s and core suburban markets seeing the most construction activity. Mixed-use projects will gain in popularity as cities insist on higher densities to mitigate automobile traffic and minimize environmental impact.

A wild card issue of Q2 may be the Supreme Court ruling on the challenge to health care subsidies offered through Healthecare.gov. If the plaintiffs in the case prevail, the viability of the entire program will be called into question, and uncertainty over the healthcare for millions of workers would be back in play.

Click the following link to download The Lee Office Brief Q1 2015

About the Author Michael Staskiewicz

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.

follow me on:

Leave a Comment: