As the temperature outside heats up, the U.S. office market sector begins to warm up. With an uptick in office employment growth, some rent growth and low levels of new construction, the office market is showing some signs of improvement.
That was the consensus of a panel of experts on a recent episode of the “Commercial Real Estate Show” radio program. My guests and I discussed a number of topics, including net absorption, vacancy rates, investment sales and rental rates.
Improvement by Numbers
Office demand is certainly affected by job growth. “Office employment growth grew at a 3.2 percent annual pace in the first half of the year, compared to 1.8% employment growth overall.” says Walter Page, director of research at CoStar Group. Eight metropolitan areas — Atlanta, Boston, Chicago, Denver and New York, as well as Orange County, San Francisco and San Jose, Calif. — have each experienced at least 1 million square feet of positive net absorption of office space so far this year, he added.
The uptick in absorption paired with only 5 million square feet of completed office space in the first half of the year has caused vacancy rates in many markets to decline to 12.1 percent or less, Page said.
The improvement in occupancy is beginning to generate an increase in rents. Gross asking rents are up 2 percent on a year-over-year basis in most markets. As rent growth continues, it will drive construction, Page said. By 2016, Page predicts 3 to 4 percent annual rent growth.
David Tennery, principal of office properties and development at Regent Partners, added that the increased demand for office space hasn’t come from just one type of office user. “It’s no longer just technology or professional services, but a very broad reach in terms of sector growth,” he said.
While that may be true, different cities are benefitting from the growth of different job types. For example, Houston is seeing the strongest demand from energy tenants, while San Francisco remains heavily invested in the technology market.
Office sales volumes year-to-date are up 10 percent over last year, Page said. Cap rates are near record lows, particularly for top-quality, core properties in top-tier locations.
However, those looking to invest in core office properties may face steep competition. Sean O’Reilly of Ernst & Young said he repeatedly hears that there is too much competition for core assets right now. “The theme over the last two years is that there’s more capital than core assets out there, and that’s caused a lot of pricing pressure,” he said. This has caused investors to shift toward secondary markets.
Tennery said that while many investors shied away from value-add assets during the past few years, there should be a big market for those assets next year.
“There used to be a fine line between distressed and value-add assets, but in the last three years it’s been a chasm,” he said. “That chasm is closing, and I think many of the banks and servicers that took these assets back have done a tremendous job, in most markets, of really nursing them along to get the buildings relatively stable and will now take those buildings to market. In 2014, I would image we’ll begin to see some good value-add, opportunistic buys again.”
While most signs point to recovery, concerns such as the possibility of rising interest rates and the reduction in space usage by some office tenants mean this sector isn’t out of the woods quite yet.
“We have seen a 20 percent reduction in space usage with a typical tenant during the last 10 years, and we’re expecting a 1 percent decline in space usage per employee going forward, so that’s an issue,” Page said.
O’Reilly added that in suburban settings, tenants are dropping from 250 square feet of space per employee to about 200 square feet. In urban settings, 150 square feet of space per employee is the norm, but some firms in intown areas have dropped that figure to 75 square feet, O’Reilly said.
As the weather cools down this fall, don’t expect the office market to cool. Expect office property sales to continue to increase. The investors in the space feel the sector is on the mend and that while interest rates are low, it’s a good time to buy. And that of course is good news if you’re considering selling.
Of the various best practices and tips shared on the show, I liked this one best. Lock in fixed-rate loans now and when possible set them up to be assumable.
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