Wednesday, July 27, 2016

U.S. Office Sector Enjoys Steady Q2 Leasing Momentum Even as Rent Growth Slows, Sales Stall

The U.S. office market continued its steady momentum in the second quarter, recording 39.4 million square feet of net absorption in the first six months of 2016, nearly equaling the 40.2 million square feet absorbed during the record-setting first half of last year.

The U.S. office vacancy rate ticked down another 15 basis points to 10.6% in the second quarter of 2016, well below the long-term historical vacancy rate of 11.3%. CoStar analysts expect the office vacancy rate to continue trending lower before bottoming out at around 10.2% in 2018, about the same as lowest point of the last real estate cycle.

"Basically, we expect to have two more years of occupancy recovery in the office market," noted Walter Page, CoStar's director of office research, who presented the Mid-Year 2016 Office Review and Forecast along with Hans Nordby, managing director for CoStar Portfolio Strategy and CoStar senior real estate economist Paul Leonard.

Several markets showed marked improvement at mid-year, including ones that were previously struggling, such as Phoenix, which posted positive absorption of 3.4 million square feet.

In Seattle, which has enjoyed a particularly strong run, Amazon's ongoing expansion helped drive 3.1 million square feet in net absorption. Even Washington DC saw a welcome return of strength in the second quarter after several years of flat demand growth. The D.C. office market absorbed a respectable 2.3 million square feet over the last four quarters.

"Finally, we’re starting to see some momentum in the D.C. marketplace, which should allow the vacancy numbers to start inching downward," said Page.

There were several notable exceptions. The energy sector slowdown and corporate relocations related to the completion of several pending build-to-suit projects played a role in Houston and Dallas, which recorded absorption declines of 2.4 million and 3.7 million square feet, respectively, since mid-year 2015. San Francisco, Raleigh, Boston and San Diego also logged declines due to a variety of factors.

But for the most part, the vast majority of office submarkets -- 66% -- saw their office vacancy decline in the second quarter, and more than half of all U.S. office submarkets have a lower vacancy rate than during the previous market peak in 2006-2007.

Demand for High Quality Space Resulting in Limited Supply

In a theme seen in many markets across the country, the supply of available space in newer, higher-quality office buildings is becoming increasingly limited. With relatively little new development in the pipeline based on historical levels, only about 81 million square feet of space is available today in buildings constructed over the last 10 years.

That total is less than half the 167 million square feet of vacant newer space that was available in 2007, according to CoStar's analysis.

"While there are some exceptions where plenty of high quality, new office space remains available, such as Houston and Washington, DC, for the most part we're really tight on nice, new space," noted Page.

As evidence, Page noted that the vacancy rate for 4- and 5-Star office properties remained unchanged at 11.7%, despite the fact that 90% of the new office space added to the market falls into that category.

Suburban office markets also continued to see increasing activity as large blocks of high-quality space become harder to find -- and more expensive -- in most major markets, with the exception of Los Angeles, Seattle, Chicago and Atlanta, where large blocks of downtown space remain readily available.

"Part of the story is that it’s now the suburbs’ turn in the cycle, and part of it is that the CBDs were so successful earlier in the recovery cycle that there’s no place left to grow," Nordby said.

As investors begin to focus on which markets are the most recession-resistant in the later innings of the recovery, certain niches such as medical office space stand out, Nordby said.

Demand growth is nearly twice as strong for medical office as for regular office, and over the long term, medical office has grown at about 1.3% annual rate compared to 0.7% for the broader office market, Page said. The medical office sector, which has never had negative demand growth, even during the two recessionary periods since 2000, had a midyear vacancy rate of 8% compared to the broader market's 10.6%.

Office construction stayed flat in the second quarter at about 130 million square feet under way, due in part of a large decline in Houston. But building activity is still slightly above its long-term average of 125 million square feet, with increased construction in D.C. and Atlanta, among other metros.


Some Cautionary Yellow Flags

While leasing and absorption levels remain robust and construction still well below historic levels, the U.S. office market did see some cautionary flags in the second quarter, including a big slowdown in office sales activity and the beginning of a slowdown in rent growth.

CoStar is projecting office rent growth will likely finish the year at an average of 3.4% and decelerate to the low 3% range over the next year. As with all trends, there will likely be a few exceptions, including the Nashville, Atlanta and Florida markets, where lower rents earlier in the cycle have limited construction. Also, rent growth in CBDs is expected to continue to outpace suburban markets.

Meanwhile, reflecting declines across all the property types, the volume of office sales completed in the first half of 2016 declined compared to the same period one year earlier, according to preliminary CoStar data.

"It's a worry," Nordby said. "A decrease in transaction volume generally portends a decrease or at least a flattening in prices."

And in another historical sign of softening demand, rising levels of surplus space placed on the sublease market by tenants, is rising in a few markets. In Houston, the contraction of large energy tenants has caused sublet space to balloon to more than 3.5% of total inventory. Companies such as Shell, ConocoPhillips, and BP have each put 500,000 square feet on the sublet market in recent quarters.
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