As expected, the Federal Reserve Bank raised its benchmark short-term rate by 25 basis points this week to a range of 0.75 percent to 1.0 percent. But the higher interest rate will have little impact on office building values, mainly because of dramatically low new office construction over the last seven years, notes John Chang, first vice president of research services for brokerage firm Marcus & Millichap Real Estate Investment. A Marcus & Millichap 2017 US Office Investment Forecast reported that 82 million sq. ft. of new office space will be delivered nationally in 2017, the peak for new office construction in the current cycle.
While a significant amount of new space will be delivered this year, it is nearly all pre-leased, according to Chang. According to Robert Slatt, a principal at the mortgage banking firm Newark Realty Capital based in San Francisco, most of the development activity he is seeing involves adaptive reuse of obsolete structures, like old warehouse buildings.
The biggest setback to sales velocity right now is uncertainty about fiscal policy and proposed changes in the tax structure, says Chang. Investors worry that if they sell a property now they will lose out on any advantages provided by the GOP’s proposed lower tax structure and are holding off selling, which is slowing transaction activity. Buyers are cautious at this point too. The office market peaked in 2015, Chang points out, flattening out last year, but remained in peak-level range through 2016 until the election and initial 25 basis point spike in the Fed rate.
“People are starting to adapt to the new environment, with investors factoring the rising cost of capital into negotiating deals,” Chang says. “There’s a modest softening in sales, but lot of things can happen to change that, like cost of available capital and strength of the dollar and stock market.”
Chang adds that commercial real estate investors favor a high-inflation environment because it pushes up rental rates.
There is still plenty of capital available for deals, but lenders are exercising discretion in favoring urban properties with a secure tenant base, the Marcus & Millichap report notes, while exercising greater scrutiny and more conservative loan underwriting for suburban office assets.
There are a few exceptions, according to Slatt, like a recent deal in which a historically conservative institutional lender financed a biotech spec project in San Carlos, Calif. He says this was surprising because the lender was an insurance company that typically only finances traditional office buildings in core markets—like those occupied by law firms and financial companies— that require minimal improvements when a space turns over.
Meanwhile, asset performance is moving in the right direction. Buoyed by continued job growth, with 2.2 million jobs added in 2016 and another 2 million predicted this year, the report forecasts net absorption of 83 million sq. ft. nationally in 2017, with another 20 basis point decline in U.S. vacancy to 14.3 percent, marking the low point of the current cycle. The reduction in vacancy will spur a 3.5 percent increase in the average asking rent.
On the other hand, job creation is expected to moderate as the labor market tightens.
Deceleration in job growth is the result of lack talent to fill available jobs, not lack of jobs, market sources claim. San Francisco remains among the 10 markets in Marcus & Millichap’s National Office Property Index (NOPI), with four new markets climbing into the top 10 from a year ago, including Raleigh, N.C. Miami-Dade and Tampa-St. Petersburg are the highest-rated Florida markets, while positive supply-and-demand dynamics have enabled Nashville, Atlanta and Charlotte, N.C. to secure high rankings as well. Minneapolis-St. Paul held the position as the highest-rated Midwest market.
While the outperformance of properties in Central Business Districts (CBD) led the office sector out of the recession, Marcus & Millichap researchers predict that suburban office locations will continue to gain ground going forward. Chang notes the trend is a continuing reflection of the Millennial influence on the office market. The influx of young professionals into urban centers boosted performance of office space as employers followed the Millennial talent to CBDs, Chang says. “As the leading edge of Millennials push into their 30s and form families, they are looking for more affordable housing and are going to the suburbs, causing companies to shift to those areas and smaller markets like Portland,” he adds, noting that the most popular markets have good mass transit and lots of retail amenities.