The Pulse of the Office Sector

Date: 08/18/2015

Market Performance

The office market is doing “Okay” at mid-year, according to Ryan Severino, Senior Economist at REIS. “That’s a technical term,” he explains with a knowing smile.

Vacancy

• 16.6, down only 10 bps since last year

Asking rents

• Grew 1.6% in 2015
• Up 3.2% year-over-year

The good news is that by growing at such a measured, steady pace, the rent growth rate is incredibly stable and strong. This consistency is a very healthy indicator.

Class & Location

Numbers-wise, class A space outperforms B and C, where vacancy compression is twice as rapid, and rents are rising faster. The hot demand is mostly focused on the top class properties. When it comes to CBD verses the ‘burbs, it’s more nuanced than people think: vacancy is indeed falling faster downtown, but suburban inventory is more than twice as large. Overall, more office is being leased in suburban areas than CBD. Despite the common rumors, the suburbs are not dead. It’s a market-by-market situation – some suburban locations are thriving, others are struggling.

Hot Markets

The tech markets lead the way with vacancy rapidly dropping and rent growth the strongest in the nation. San Francisco, San Jose, Seattle, Boston – this is where you’ll find the industries consistently creating demand for office. While this year the energy sector has struggled with falling oil prices, Dallas is doing a great job attracting companies in a variety of industries. Also Miami, as the unofficial capitol of Latin American business, has a strong and diverse business market. An added plus: the residential market there has recovered quite nicely. In Atlanta we have seen higher rent growth and occupancy gains than we have seen in many years. Office tenants with expiring leases are experienced some real rate shock. Investors are interested in Atlanta as cap rates are higher than the primary markets.

REIS is bullish on the Office market.

“We see better performance in the economy over next 3-5 years than the past 3-5,” predicts Severino. “More jobs are being created in the higher value-add service sector, and these are office-using jobs. The second half of this recovery will be better than first.”

Cap Rates

With rising rents, burgeoning occupancy, tight supply, what’s happening to cap rates? Cap rate compression is not as rapid as it was a few years back. In 2015 Class A compressed further than B or C. Lowest cap rates can be found in NY, DC, and northern California since investors remain focused on markets they understand. Hot markets:   Low single digits– 3.0-5.0% Others:            High 7.0 to 9.0%, low double digits in some areas

New Construction

Building new is not at zero, but so little construction is ongoing that it could be a glorified rounding error. There’s been a small uptick in speculative development, but desirable land is quite scarce and costs are sky high.

Office Profits in Flyover Country

Not everyone wants to or can handle investing in the gateway markets. So I asked James Cook, National Director of Analytics at Xceligent to give us some insight into what’s happening in other parts of the country.

Is There Much Interest in the Secondary and Tertiary Markets?

Investors and brokers are really interested in what’s going on beyond the core markets. Low yields from treasuries have driven interest in core markets, but with cap rates so low some investors are chasing yield into secondary and tertiary markets. Last month Xceligent held a panel called ‘Journey to the Center of America,’ explained Cook. “These markets are outside the usual comfort zone of institutional investors, but they’re taking notice.”

Testing Assumptions

Often we hold beliefs that contradict what the data tells us, so Xceligent under Cook’s direction looked in to some key assumptions about the Office market.

Any Recommendations?

More institutional investment is heading to Portland, Nashville, and Cleveland. “If it were my money I’d bet on Portland,” opined Cook. “It’s very attractive to Millennials.”

What Developers Want

We asked John Heagy, Senior Managing Director for Hines, a worldwide developer of Office properties since 1957, to talk about the state of Office development today. “If you’d asked me ten years ago,” Heagy laughed, “I would have predicted this: today 90% of our building is happening on 10% of available land.” Heagy’s firm is in all of the gateway cities, and actively building in secondary cities. Atlanta, Raleigh, Charlotte, and Nashville have ongoing new projects. “Today’s tenants demand walkable environments, connectivity with transit, and the potential for a traffic-free lifestyle. This is huge with younger generations, our customers of the future.”

Corporate Values & Office Features

The perfect office enhances and supports the function and success of its inhabitants. Similarly, office features should reflect the company’s nature. These go hand in glove according to Heagy. Many contemporary firms focus on a collaborative process, thus the open plan, shared workspace designs that have come to represent modern office. “The space must reflect the company goals. The firm’s function drives the design and location of new custom workplaces.” In the past lobbies served a different purpose– but today that space is expected to be dedicated to business activity. Businesses now require a greater density, fewer square feet per employee, and older buildings can be really challenged to handle the retrofitting. Air handling and power supplies require a certain amount of space, and the amount of wiring for bandwidth is only increasing. Companies are in competition to hire talented people, so office amenities and more importantly location are critical to a firm’s performance. In the past office a company went where the boss had his home. Today location must meet the demands of the workforce.

The 3, 30, 300 Rule:

To run your office you’ll spend: $3 sf on utilities $30 sf on office space $300 sf on the salary of the occupant

Bigger Challenge in Secondary or Tertiary?

Heagy noted it takes more planning and a careful strategy to invest in the smaller markets. A project will be slower to lease up, so solidify your preleasing, ideally with a specific tenant, before you commit. But it all depends on the market. Nashville Office is as hot as any gateway market at the moment. And Atlanta is going strong. “Normally we only build when we have a lead tenant. We like to see at least 50% of the space preleased. In the past we’ve only built spec in major gateways, but now we’re building in North Fulton and Midtown markets of Atlanta.”

How Long Will This Last?

With the measured pace of steady growth and very low cost of money, the sector continues to improve, and according to Heagy and others in the business, it feels like there’s more growth to come. The downturn created a great deal of pent-up demand, with lack of construction pushing up rents. Companies have been cautiously growing, not over spending. Even the imminent rise in interest rates signals an improvement in the economy.