Where is the Demand for Office?

Where is the Demand for Office?

The national office vacancy rate remained unchanged from the first to the second quarter, mired at 16.6 percent and moving down just 30 basis points over the past 12 months. Monthly job growth has been choppy as of late, though recent months have been more heartening. And while we still expect an uptick in economic activity over the course of the year, GDP growth projections have generally been ratcheted downwards. This implies another year of slow, but hopefully steady, improvement in office fundamentals.

Occupied stock rose by 8.4 million sq. ft., a roughly 13 percent increase over last quarter’s total. This just barely outpaced new completions of 8.3 million sq. ft. in the second quarter. While this was not sufficient to nudge vacancies downwards, it still provides evidence of a slow simmer in terms of office leasing activity. Employers are hiring, albeit slowly, and are leasing up space at the same plodding pace.

Not all office districts are created equal

Vacancy in the central business districts (CBDs) was at 13.3 percent in the second quarter, and remains far below that of the suburbs (which are at 18.3 percent). This is quite the reversal from the 1990s, when suburban vacancy was below CBD vacancy because employers were fleeing high crime rates and poor schools. Today, a number of employers are deciding to locate in (or relocate to) CBDs because they are cleaner, safer and offer amenities not often found in the suburbs. They are also following their employee base, including many young adults who prefer to live in urban areas.

The other key issue affecting suburban areas is the relatively larger inventory vis-à-vis CBDs. From 1990 to 2010, over 80 percent of new construction occurred in suburban areas; when the recession of 2008-2009 hit, suburban office buildings suffered more. Now they are dealing with a relative supply glut, complicating dampened demand. This gulf in vacancy between CBDs and suburbs is likely to persist, even as they both continue to see further vacancy compression. The office market is in recovery mode, but some markets are recovering faster than others.

Asking and effective rents both grew by 0.7 percent in the second quarter, around a 20 basis point slowdown relative to first quarter figures. While there has not been a significant component of seasonality identified for office leasing (unlike apartment leasing, which is affected by the tides of spring and summer household movements), the last two to three years show that rent growth tends to be slow in the second quarter. On the plus side, year-over-year growth is showing slow improvements. Asking and effective rents increased 3.2 percent and 3.3 percent, respectively, over the past 12 months. This is slightly above last quarter’s totals, but well above the low 2 percent annual increases exhibited early in 2014.

Market highlights

The share of markets posting positive absorption over the last five quarters is certainly heartening. Sixty-eight out of Reis’s top 82 primary markets posted an increase in occupied stock in the second quarter, a trend that has generally been improving since early 2014. Likewise, an increasing number of markets are posting rising effective rents; only seven out of 82 markets posted flat or declining effective rents in the second quarter. For most of the recovery period from 2011 onwards, the markets that posted the most impressive measures of improvement had been the technology- and energy-oriented metros. Still, a lot of the largest rent increases are still concentrated in a small number of metros, mainly tech-centric markets.

The recent debacle of low energy prices, however, has ended the run of some energy markets. Houston, the center of the energy industry in the U.S., continues to struggle with the fallout from the decline in oil prices while construction remains strong. This pushed vacancy in Houston to reach 15.6 percent this quarter. That is an increase of 50 basis points versus the first quarter and 120 basis points over the last 12 months. Although the longer- term prospects of the Houston market are far from dismal, the short-term outlook will likely continue to be a challenge.

Washington, D.C., and New York remain the two tightest markets in the country as measured by vacancy rate. D.C. has a vacancy rate of 9.3 percent, while New York has a vacancy rate of 9.6 percent. San Francisco, the third-tightest market in the country, continues to gain ground on both of these markets. At 10.8 percent, San Francisco’s vacancy rate finally breached the 11 percent barrier, falling 60 basis points versus last quarter.

Near-term outlook

Reis expects office fundamentals to improve at a slightly faster rate for the remainder of the year. Although our GDP projections have been lowered to 2.2 percent-2.4 percent, this still means that the bulk of economic growth will be concentrated in the latter half of the year, which should be a boon for rents and occupancies. If a ramp up in job creation does materialize, expect office vacancies to decline by 20 to 30 basis points, and rent growth to be close to 3.0 percent.

 

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