Monday, January 26, 2015

OFFICE OUTLOOK: Will 2015 Be the Year Demand Shifts Into Higher Gear?

While demand for apartments remained strong across most markets in 2014, office demand remained rather spotty, with traditional office strongholds such as Manhattan and Washington DC struggling while tech and energy hotspots such as San Francisco, Houston and Denver experiencing explosive growth in the office sector.

Total U.S. office net absorption is projected to enjoy robust 21% growth in 2015 to 95 million square feet, according to Director of Office Research Walter Page with CoStar Portfolio Strategy. And because new supply is still well below historical levels and growing at just half the rate of demand, office vacancy rates continue to slowly decline and are expected to gradually dip toward a low of around 11% in late 2016. As vacancy has declined, rent growth has picked up, rising at a respectiable 3.6% annual rate in the third quarter, versus 2.6% for the same period one year earlier.

With the U.S. economy in expansion mode and construction largely in check, the question facing office landlords in 2015 is, which way is the office market headed? For most, the answer may largely depend on your location.

"We’re very bullish on the marketplace right now, at least through the first half of 2015, Heading into 2015, we continue to see job growth in the Silicon Valley, with interest rates staying low and the stock market high. There are a lot of larger tenants that have been in the marketplace, and when those deals land, there are other new tenants backfilling their requirements."

While primary tech-driven markets are expected to continue see strong demand, secondary markets that are seeing job growth, such as Portland, Austin, Nashville, Salt Lake City, Atlanta and Raleigh-Durham, are also expected to get a boost of activity as tech companies look to tap into markets that have highly-skilled labor -- not to mention the bonus of lower real estate costs compared to markets like San Francisco and Silicon Valley.

However, tech's twin in driving driving U.S. office growth, the energy sector, has yet to fully realize the slowdown suggested by falling oil prices.

"Activity in energy-led markets will undoubtedly be lower than in recent years. In the fourth quarter alone, Houston saw seven of its major submarket hubs post rent declines in the 1% to 3% range over the quarter and job growth prospects remain positive, but forecasts are down 25% from actual levels achieved in the past few months."

For the remainder of office markets, Sikaitis said he is increasingly optimistic for increased office leasing activity.

"The recovery is consistently building across and through markets with expansionary leasing activity on the rise and confidence among landlords increasing, fueling rental growth across nearly 90% of markets tracked."

Investment capital is expected to keep moving further out on the occupancy and leasing risk curve in search of higher yields, moving more aggressively into other tiers of office markets and select submarkets of top metros in 2015.

"Yields have been severely compressed in gateway cities. We have already witnessed and I suspect the trend will continue much in the same way it did in the mid-2000s, where investors will target secondary and tertiary markets for yield."

An example of a lower-tier market benefitting from the rising economy is Charleston, SC, where some 22% of employers plan to increase hiring in the coming year.

"This is of little surprise to office developers and owners who are witnessing declining vacancy and rising rents, Office vacancy rates in the high-demand submarkets of Mount Pleasant and Peninsula Charleston have reached near zero status.

In fact, owners of well-positioned office properties are welcoming vacancies that give them an opportunity to re-tenant the space at higher rates, and tenants who insist on prime Class A locations and amenities have very few choices left in th emarket right now," adding that investors are met with multiple offers for office properties, most of which never reach the open market.

“The result will be sharp increases in asking office rents in 2015 while market forces race to develop new buildings to catch up with the surge in demand,” he added.

Increasingly, the focus is expected to shift to redevelopment and repositioning of older Class B buildings versus ground-up office development in the coming year.

"The push for creative or lifestyle office is no longer a fad but here to stay," said AY's Vittone. "Not only are investors/developers seeking to reposition Class B office product, but many are seeking antiquated, low-clear industrial buildings with decent parking as creative office conversions."

In Silicon Valley, where Class A office space trades at a premium after large tech companies like Google and LinkedIn scooped up huge blocks of space, "we’ve also seen startups take the single and two-story R&D product and convert it to a lower-cost but still very nice alternative product," Gabrielson added.

Lending terms will get more aggressive for office development and acquisition over the next 12 months.

"There is a backlog of equity and debt chasing deals in the marketplace. Lenders need to get money out and I would not be surprised to see credit spreads tighten anywhere from 10 to 25 basis points," Vittone added.

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