Office Market Outlook
Employment Gains Drive Office Outlook
Solid gains in office-using employment are driving renewed demand for space, pushing occupancy rates and effective rents higher across a wide range of US markets. Prospective tenants have shown a clear preference for centrally located properties, but demand for suburban office space is showing signs of improvement as its cost advantages over the urban core become more pronounced. Investors in the sector may balk at record-low cap rates for large trophy properties; however, in the small- and mid-cap segments of the market, buyers will find less aggressive pricing and improving access to mortgages through regional and community banks and conduit lenders. In exploring those opportunities, entrepreneurial investors will encounter a growing class of tenants preferring flexible lease structures and co-working arrangements in addition to more traditional long-term lease rolls.
Long-Awaited Job Gains
Never in the recent history of the American economy has it taken so long to recover the jobs lost over the course of a downturn. That milestone was reached in 2014, more than 6 years after the Great Recession first took hold. Employers added more than 3 million jobs over the year, finally recouping losses from the crisis-era cull in the strongest showing for job creation since the dot-com boom.
Until recently, the lagging recovery in jobs — specifically in office-using employment — has been one of the primary drags on office sector fundamentals. Momentum in leasing activity had been concentrated in urban cores, often at the expense of suburban office properties, and in a subset of markets with high exposure to the energy and technology sectors. Leasing has also picked up as job gains have broadened and firms have grown more confident in their expectations of business activity. As a share of the office inventory, net absorption in 2014 was nearly double its long-term average. The national vacancy rate fell below 15% for the first time in 7 years, owing primarily to an uptick in leasing in central business districts (CBDs). Topping the list of the strongest CBDs, the vacancy rate in Manhattan trended below 10% in early 2015, contesting San Francisco for the title of tightest gateway office market. In Midtown South, one of New York’s tech and new media hubs, the vacancy rate has fallen below 5%, driving the largest rent gains of any submarket in the country.
While national leasing activity moderated in the early part of 2015, the medium-term outlook for space demand is healthy. Returning to the underlying drivers of space demand in the labor market, job openings climbed above 5 million positions in the early part of the year – the highest level since 2001. A large percentage of those new jobs fall into office-using occupations, including key subsets of professional and business services, supporting the overall outlook for the sector. Investors are naturally concerned that place-of-work trends and more modern space layouts will undermine the traditional relationship between employment and space demand. While those are credible concerns, limited construction in most markets means the balance of supply and demand is projected to weigh in favor of occupancy and rent gains for the immediate future.
Office Market Statistics in 2015
Office development activity is on the rise, albeit still at a restrained pace when compared to the apartment sector. Measured in terms of spending, investment in new office properties jumped nearly 25% in 2014 to $36.9 billion. While that is substantially lower than the pre-crisis peak in spending, some gateway markets are seeing a boom in activity unprecedented in recent history. At the leading edge of investment in New York City, Hudson Yards will introduce more than 17 million square feet of new commercial and residential space to the West Side of Manhattan. As the largest private development in US history, its 5 new office towers will redefine the Manhattan skyline.
In addition to New York, other leading markets for office construction include Austin, Dallas, Houston, San Francisco, San Jose, and Seattle. In each case, properties under construction represent more than 5% of the in-place inventory. The drop in oil prices over the last year offers a stark reminder that the relative success of new office projects depends critically on factors outside the immediate control of investors. In Houston – which accounts for nearly 20% of all current office construction in the United States, and an even larger share of spec development – demand conditions have softened appreciably in late 2014 and early 2015.
Asking rents in the office sector increased nationally by 5.2% in 2014, nearly twice the pace of the prior year. Gains were generally stronger in central business districts and weaker for suburban properties, where lease rollovers remain dilutive to cash flow in many locales.
The top markets for rent growth included Austin, New York, San Francisco, and San Jose. In the strongest submarkets, including those catering most directly to technology and new media companies, rent growth rates climbed to double-digits last year, and show few signs of losing momentum midway through 2015.
Anticipating continued improvement in fundamentals, the office sector reached a milestone in 2014 as values in gateway and primary markets surpassed pre-crisis levels. Nationally, value-weighted cap rates based on underwriting of property sales and mortgage refinancings declined to an average of 5.8%, and were often substantially lower for trophy central business district properties. New York and San Francisco both reported CBD cap rates just below 5%, followed closely by Los Angeles, Boston, Washington, DC, and Orange County. Suburban cap rates were generally between 30 and 100 basis points higher. Detroit was among the notable exceptions, with CBD office cap rates 40 basis points higher than cap rates outside the urban core.
Market Cap Rates
Value-weighted national average office cap rates fell to 5.8% in 2014, pushed lower by record pricing in New York City and other gateway markets. Cap rates varied significantly across a wider range of primary and secondary markets, urban, and suburban locales. Not weighted by transaction size, the national average for central business district properties was 70 basis points higher, at 6.5%. Suburban cap rates were generally higher, averaging 6.9%. The highest suburban office cap rates were in the Midwest, capping out in Detroit at 8.7%.
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