Thursday, January 5, 2017

OFFICE OUTLOOK: Slowing Absorption, New Supply Raise Caution as Momentum Seen Shifting from CBDs to Suburban, Second-Tier Metros

Analysts are seeing the first hint of caution in the U.S. office market after ending the year with slowing absorption ahead of increasing new supply. 

Meanwhile, the nascent recovery of suburban and second-tier office markets that began to take hold in 2016 is expected to accelerate in 2017, outperforming CBDs and richly priced U.S. gateway office markets in terms of leasing and absorption in 2017. 

Major brokerage firms have different takes on the U.S. office market outlook. CBRE Group's forecast sees a moderate slowdown in 2017 with a slight decline in total net absorption and an uptick in the national vacancy rate. Jones Lang LaSalle notes a combination of decelerating leasing velocity at year-end marked by a low level of "mega leases" resulted in just 6.5 million square feet of net absorption during the fourth quarter. Near-full employment and a shortage of skilled talent suppressed leasing activity in several major tech hubs, according to JLL. 

Cushman & Wakefield on the other hand sees a modest increase in net absorption in 2017, with the vacancy rate holding steady through the year. 

CBRE expects approximately 50 million square feet of new office space will be completed in 2017. While still low compared with previous cycles, that would comprise the largest amount of new office supply since 2009. 

Office rents are expected to slow their growth from 4% to 4.5% seen in 2014-2015, down to an average 1.5% in 2017, CBRE said in the report overseen by Americas Head of Research Spencer Levy, Chief Economist Jeffrey Havsy and Senior Managing Economist Timothy Savage. 

Road to Recovery Continues for Suburbs?

In its annual list of predictions for CRE markets during the coming year, CoStar Portfolio Strategy forecasts that projected returns of 6% on suburban properties will exceed returns of 4.9% from fully valued CBD and other urban assets. 

CoStar analysts also see second-tier markets generating the lion's share of rent growth in 2017. Average U.S. rents, which have grown 16.8% in an uneven expansion since bottoming in 2010, will continue to see growth branch out as markets cool in tech hubs such as the San Francisco Bay Area, Boston, Denver and Austin. Office rents in such secondary markets as Philadelphia, Minneapolis, San Diego and Tampa are projected to grow by a collective 3.3% in 2017, surpassing the national average of 2.8% for the first time during the recovery, according to CoStar managing consultant Paul Leonard. 

"We’re now in the seventh year of the expansion, and the early-recovery markets are finally starting to show signs of cooling," Leonard said. "As developers have responded with new supply, job growth has slowed and office absorption rates have decelerated. The best rent growth over the next year should be in second-tier markets which have limited new supply under way." 

Technology sector growth, which has accounted for nearly one-fifth of major office leasing since 2014, will be critical for continued gains in office-using employment and office demand, CBRE noted in its outlook. 

Tech employment growth slowed to 4% in 2016, well below the five-year average of 7.3%. Finding skilled labor in an increasingly competitive environment "will be critically important" for continued expansion and office demand in established hubs like the San Francisco Bay Area as well as emerging tech sectors in lower cost markets such as Phoenix, Atlanta and Portland, CBRE said. 

With solid office job growth expected throughout 2017 and 2018, Cushman & Wakefield forecasters said there is still runway for the office market. Even before the election, U.S. economic fundamentals were showing signs of heating up, noted Kevin Thorpe, Cushman & Wakefield’s global chief economist. 

"We observed a big GDP number in the third quarter, accelerating wage growth, surging consumer confidence: a string of really robust trends were already forming," Thorpe said. "Now, when you layer in the expected tax cuts and spending multipliers from the new [Trump] administration, it creates an even stronger economic backdrop for the property markets heading into 2017." 

John Chang, first vice president, research services for Marcus & Millichap, agreed that office markets in the west and south will in general see the strongest office-using job growth this year, including many slower recovery markets with little office construction under way such as the Florida metros. Tenants interested in the most desirable submarkets and the highest quality buildings currently have limited options in these metros, giving landlords greater leverage until rents increase to the point that justifies new development. 

Fitch Ratings said it also expects healthy and above-average U.S. office sector fundamentals in 2017, with office space demand growth of 1.1% outpacing 0.9% growth in new supply. However, the ongoing densification trend of companies allocating fewer office square feet per employee will temper demand growth, particularly from legal, financial and business service tenants that are downsizing their footprints when leases expire.

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