On a recent episode of the Commercial Real Estate Show we caught up with CoStar’s Walter Page for the latest on Office sector performance, including the stellar third quarter numbers.
Vacancy is down to 11%, having declined 20 basis points this quarter and 60 bps Year-to-Date. Now at it’s lowest level this cycle, with 5 years of declining vacancy.
Rent growth sampled nationwide is currently 4.3% with inflation expected at 1.7%.; last year’s came in at 3.8%. Certain markets have had significant increases in the past year. San Francisco CBD has been rising year-over-year at a scorching 19%.
Demand is exceptional: 30 million square feet net absorption this quarter, 101 million sf for the past year, puts the rate of demand growth at 1.4%. Job growth is close to 2% nationwide, so demand growth could increase in the future.
Construction is picking up: 15 million sf delivered past quarter, 128 million sf underway nationwide, up 14% for the year.
For example, NYC has 14 million sf of new Office underway, Houston 12 million, and there are 8 markets with 4 to 8 million under construction. Over half the substantial US markets show office construction picking up.
Some doubt the strength of this office market, but the numbers are compelling.
Vacancy rates for those newer buildings are notably below the national average; another indication there’s a shortage of new space. The demand for ‘nice’ class 4- and 5-star is three times the demand for lesser quality office. You can expect 2.5% growth in demand for A and A+ space compared to .8% for B and C space.
‘Flight to quality’ is a persistent trend. The way we work today is more collaborative, and as the job market has tightened, companies use location and office amenities to recruit and retain. If you’re asking people to work with less space, it needs to be well designed with great amenities.
Don’t Dis the Burbs
Everyone talks about the CBDs but the suburbs are growing as well. It’s partly a matter of volume; the hot CBDs are so much smaller than the surrounding suburban markets.
YTD we have absorbed about 10 million square feet in the central business districts (CBDs), an annual rate of .7%. The suburbs are growing at nearly double that rate: 1.3%.
Clearly there is strong demand for both. Close in suburban with transit are the prime choices, fetching the best prices.
Page expects vacancy rates, currently at 11%, to continue declining to 10.5 to 10.3, bottoming out in 2017. Rent growth currently at 4.3% will begin to moderate going forward, to the 2.5 to 3% range, still well above inflation.
Sales volume today is remarkably high. So far we have $92 billion on the books for calendar 2015, and the record to beat is $117 billion in first 3 quarters. There’s demand, but of course, there’s also plenty of capital looking for deals, and Office has been a good performer, standing up well compared to stock and bond markets.
This year the top assets haven’t compressed as much as the class C properties. Apparently investors are willing to take more risk. At the high-end cap rates are about 5%, and class C has fallen by 70 bps over the past year to 7.1%. Opportunistic investors have plenty of capital, and they are looking for yield somewhere.
Impact of Rising Interest Rates
Pages believes the markets are already anticipating the rise in interest rates. In the next few years we’ll see a 10-20 bps increase in cap rates, while interest rates are expected to be up 70 bps.
When I asked Page if office is at the top of the market, he said, for cap rates yes, for prices, no. Page explained embedded growth remains in the market. That’s the value of today’s rent verses the current market rents. In most cases it’s typically about 10%. In San Francisco that difference is 33%. NOI and rent growth will vastly outpace the cap rate increase and keep the values strong, if not rising.
That’s why we’re seeing so much volume in this market.
Where to Invest
Find markets with excellent drivers for growth and very little construction. Atlanta and East Bay, for instance, have good opportunity. Rents aren’t high enough to support widespread construction. Also look into Florida markets, Phoenix, and Denver.
Houston is where investors are shying away, although not as much as Page would expect. Houston is over- supplied. Rents will decline from 5 – 7% over the next few years.
Tenants Make the World Go Round
Walter Page reports the biggest trend in the office world is the continuing reduction in space per employee, currently averaging 235 sf per employee, down 10% from 2000. He expects further shrinkage of around .5% per year. Related significant trends are telecommuting, open and collaborative workspace and the flight to quality.
I talked with Richard Rhodes of Cresa about the trends he is seeing in the office market. He commented that Live-Work-Play developments and how they’re transforming the business is a major trend. Transit is the key. Speculative development is not happening randomly on the outskirts of cities. Today it must be transit related and mixed use.
Governmental incentives trends are driven by growth. Localities that want growth must offer incentives. There are incentives that localities have enacted by law, and there are those you can negotiate. A savvy tenant needs to work both angles.
When it comes to landlords’ incentives, tenants can always get something by negotiating: improvements, concessions, maybe abatement. After all, a tenant is necessary to the landlord’s success. But today’s landlords are holding their ground on rental rates.
We’re still bouncing an economy off the bottom; and Rhodes reports demand is only just coming back strong. During the downturn tenants became much more fiscally conscious. This resulted in more vacancy when they learned they could do more with less.
Office is no longer one size fits all. The tech market wants less than 200 sf per person in their offices these days. Rhodes say he would not be surprised if the square footage per employee increases slightly as the economy improves.
Current Trends in Office Design
The cube farm is dead, says Dave Brown, of TVS Design, an architectural firm building office properties around the country.
“Everything on our drawing board today designed to build work environments that enhance creativity: team rooms, group workstations. Spaces are open and flexible with fewer and smaller individual dedicated workspaces. We eliminate drywall partitions whenever possible to let in the light and the view.”
Sustainable design and energy efficiency are the hot factors in design today.
TVS is building a campus project designed to be Net Zero for power and water. Now that LEED certified has become mainstream, the next frontier is Net Zero: each building producing all the energy and water it consumes. Is this even possible? Apparently. California has mandated that by 2020 all residential projects will be Net Zero and by 2030 all commercial projects.
Leading the way in environmental progress, California represents a serious chunk of commerce. It’s the 9th largest economy on the planet. It’s expected this will spur innovations and development of new technology. Yet Brown points out there are still seven states with no minimum energy codes on their books.
“We used to think LED lighting was experimental,” he noted. “Ten years ago it was terribly expensive and many thought it would never replace CFCs. Now it’s replacing commercial light sources due to the enormous energy reduction. It costs a bit more for fixtures and bulbs, but you get many multiples of hours of service from them and a higher quality light. And the best part: less than 2% of the energy costs.”
It’s tough retrofitting older buildings to today’s standards. Energy efficiency, network wiring, open workspaces can be difficult. Today’s workforce consists of 80 million Millennials who want to walk to work and live in ecologically sound environments. They do not want dad’s office building.
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