Office Sector Strategies

Date: 11/25/2014

Good news! Office sector performance for 2014 has been steady, positive and right where it was expected to be.  That’s great to hear, because it reflects well on the entire economy. I got the latest details from Walter Page, Director of Research at the CoStar Group on a recent episode of the Commercial Real Estate Show.

Great Fundamentals
“We’ve just completed the best quarter yet. Office vacancies are down to 11.6%, from 12.1% a year ago. This number has fallen for more than 4 years running, and we’re close to 2005 levels.”

Page noted that as demand rises, so do rents: nationwide, office rents have risen 3.6% year-to-date, up from 2.6% last year.  Driving these improvements is excellent net absorption. This quarter: over 23 million square feet, making 77 million for the year. Office is clearly continuing its upswing.

Trends & Patterns
I asked my guest what kinds of patterns are playing out in various markets and property classes. Page identified three important trends:

1. Tenants want ‘nice’ space:

Four & five star, or Class A, space makes up two thirds of the demand.  High-end, good urban or suburban locations are the hottest properties.

2. Technology, energy and healthcare markets are thriving:

In this recovery San Francisco rents are up 60%, Houston 40%. Healthcare office has very low vacancy rates.

3. Average square feet per employee contracting:

Many office tenants are using less space per job, incorporating telework, shared workspaces, resulting in a 15% reduction in typical space over the past 12 years.

What Investors Should Know
These steady numbers indicate that the market is settling down, Page says. Tailwinds and shadow inventory are no longer a significant influence on the market.

Cap rates peaked at about 8.6, and have declined 2 points for institutional investors, remaining stable for the past six months.  In general, a Class A property will go for a cap of around 6.6%, and Class B for approximately 7.4%

If you are in need of financing there is plenty of capital available, but lenders like to see good occupancy. Particularly for new construction, preleasing requirements may run as high as 30 to 45% percent.

New Construction
There is new product in the pipeline, particularly in the most active markets: 100 million square feet is under way nationwide. New office construction is up 25% for the year. But nationwide new supply is not going to surge. Construction costs keep rising, and rents still don’t justify construction, except maybe in major markets. Developers are waiting for higher rents.

Trends in Office Space
Michael Kruklinski, head of Real Estate in the Americas for Siemens, the global technology giant, talked about the rollout of the new program called ‘WOW’ (for ‘Way of Working,’), transforming Siemens offices around the globe.

No more corner office or private cubicles, employees bring their mobile and laptop to shared workstations. I had to know: why are they moving to this open-plan use of space?

“We looked at trend setters like Google and Facebook and how they are successful at attracting and retaining new talent,” said Kruklinski. “People are actually talking to each other again! We’ve see rates of inter-office email traffic lowered by 30%.”

These trends can save money by reducing the office footprint substantially. With desk sharing ratios of 1:1.3 to 1:1.5, Siemens anticipates saving as much as 30%. But the intention is bigger than that: it’s a cultural shift to increase employee satisfaction, as well as improve management and communication. “We’ve enhanced our community space and created somewhere people want to be. At the same time, not everyone needs to be in the office all the time. More employees are working remotely, which improves their work-life balance.”

That sounds like a big change for some office cultures, but Siemens is one firm that’s making it work.

Sustainability & Energy in the Office

I talked with Steven Ring, Managing Director of Cushman & Wakefield in San Francisco, about the California office market. It’s booming, as we know.

He described it as a ‘Gold Rush.’ And he’s not at all pessimistic. We talked about environmentally friendly office space and LEED certification.

“This isn’t just trendy, now it’s a bottom line benefit. It reflects in net income and it’s expected by tenants, so that’s the way we do business.”  Sustainability has become a factor that not only reduces costs, it attracts top talent.

If you’re an owner who wants to improve sustainability, Ring recommends that you start simply. Change out the lighting and lighting controls, invest in water saving devices, and look into new windows, especially in an older building.

“We know that California’s not like the rest of the country,” Ring said.  “But we do take the lead, demonstrating the real benefit to tenants.”

An Owners View
For the owner’s point of view, I talked to Jim Bacchetta, VP at Highwoods Properties, a REIT that owns and  operates hundreds of office properties in 10 US markets.

Jim reported a solid 10 percent rent growth over the past 2 years; in fact effective rates could be closer to 15%, since concessions are down. And this looks to continue.  “Things are better than they have been in a long time,” said Bacchetta.  “We have rising demand, not robust, but steady. Space absorption and job creation are ongoing.”

He wasn’t too concerned about offices shrinking.  In the markets they serve, in the south and east, occupancy and density are constrained by availability of parking or good rail transit. Highwoods does see a small trend toward less ‘me’ space and more ‘we’ space, Bacchetta noted, but traditional firms like law firms aren’t going to give up their private offices.

Time to Sell or Build?
The investment market is getting a little hot, almost ‘frothy.’ It’s a great time for sellers, but it’s frustrating for buyers. Everyone wants good quality assets. Cap rates are in the sub-sevens, with everyone chasing the best assets in the best markets.

Bacchetta doesn’t see interest rates as much of a factor, since the big buyers aren’t dependent on borrowing.

“We’re building in a few of our markets, but only build-to-suit.  Construction costs are approaching $400 per square foot, so no one is building on spec,” he noted. “Rents have to get higher before much more gets on the drawing board.”

Looking Ahead to 2015
Office demand will continue to experience steady growth, especially since office job growth is outpacing job numbers. Over 90 million square feet of net absorption is anticipated in 2015. Rent growth is expected to continue in the range of 3.5 – 4.0% throughout the next year.

Despite the amount of new office in the pipeline, don’t expect construction to begin to affect demand until well into 2017.

Overall it looks like 2015 is a great time to make a move. Definitely if you want to sell! If you’re a savvy investor, now is a good time to begin smart projects: fixing ‘broken’ real estate and value-add investing in good quality assets.

According to the signs, it’s still early enough in the cycle to reap the steadily improving occupancy and rents over the next year and beyond.

Michael Bull, CCIM, is the host of the Commercial Real Estate Show heard on 40 radio stations, iTunes, YouTube and the show web site www.CREshow.com. Michael is also an active broker and advisor as CEO of Bull Realty, Inc., a U.S. commercial real estate sales, leasing and advisory firm headquartered in Atlanta. Connect with Michael on Twitter and LinkedIn.