Office Market Remains Stuck in a Rut

 and  - NREIonline.com

The national vacancy rate for office properties remained unchanged during the fourth quarter at 16.9 percent. Given how slowly the office sector’s recovery has progressed, this is not necessarily reason for worry.

Since the third quarter of 2007 the national vacancy rate hasn’t declined by more than 10 basis points in any given quarter. For all of 2013, the vacancy rate fell by just 20 basis points, roughly comparable to the 30 basis point decline in 2012.

National vacancies remain elevated at 440 basis points above the sector’s cyclical low, recorded in the third quarter of 2007, before the recession began that December. Tepid supply growth and lackluster demand have remained largely in balance during this recovery, accounting for the slow pace of vacancy compression.

 

 

With most employment growth coming from low-paying, low-skilled jobs that do not utilize office space, demand remains weak. The amount of occupied stock rose by 8.9 million sq. ft. in the fourth quarter. This is a meager increase from the 7.6 million sq. ft. that were absorbed during the third quarter. This was, however, largely due to a jump in completions. For the quarter, 9.3 million sq. ft. came on-line, up from last quarter’s 6.3 million sq. ft. of new construction.

This dynamic between net absorption and construction held throughout the year. For 2013, quarterly net absorption averaged 7.1 million sq. ft., a 69 percent increase from 2012′s average of 4.2 million sq. ft. For construction, the quarterly average was 6.5 million sq. ft., a 109 percent increase from 2012′s average of 3.1. Demand certainly increased in 2013, with office buildings entering the market mostly occupied (or leasing up quickly). This is in line with strict requirements for pre-leasing from lenders that provide construction and development financing.

The bottom line is that until the growth rate in high-wage, high-skill jobs that require office space accelerates expect slack demand for existing inventory to be the norm and vacancy compression to be slow but steady.

Rent growth plods along

Asking and effective rents both grew by 0.7 percent during the fourth quarter. Asking and effective rents have now risen for 13 consecutive quarters. During 2013 the average asking rent increased by 2.1 percent while effective rent grew by 2.2 percent. This was somewhat better than 2012′s performance when asking rents grew by 1.8 percent while effective rents grew by 2.0 percent.

 

 

Unfortunately, there is too much vacant space for market dynamics to be conducive to significant rent growth. With the national vacancy rate at 16.9 percent and declining slowly, landlords remain unable to drive asking rents upward or pull back on lease concessions. That does not mean that rents are unable to slowly creep up—as they did in 2013—but stronger, healthier rent growth is only possible at far lower vacancy rates such as were observed before the recession. Reis’ historical data indicates that national vacancies need to compress by another 300 basis points before rent growth accelerates on a broader basis. Given the pace of vacancy declines, it will take another few years to get there.

Top metros reap outsized gains

In the current market environment, weakness at the national level does belie strength found in a handful of metropolitan markets and selected submarkets. With the technology and energy industries  continuing to grow and create a meaningful amount of high-wage office-using jobs, the performance of markets with a concentration of companies in these industries continues to excel. This is a familiar trend over the last few years.  The markets with the highest year-over-year effective rent growth in the fourth quarter were San Jose (+5.0 percent), San Francisco (+4.5 percent), New York (+4.2 percent), Houston (+3.7 percent), Seattle (+3.0 percent), Boston (+2.9 percent) andDallas (+2.8 percent).  Also at the top of the list was Orange County (+2.8 percent), a metro we haven’t mentioned much.  A combination of recovering tourism and an increase in demand for space from the healthcare industry has helped support the metro’s office market. Orange County ranked fourth in terms of quarterly effective rent growth (+1.3 percent) in the last three months of the year.

New York has reclaimed the title of the tightest market from Washington, D.C., with a 9.9 percent vacancy rate at the end of the fourth quarter of 2013. Washington fell to second place at 10.3 percent. While both markets experienced vacancy rate increases during the quarter, Washington’s rise is more troubling. While New York’s was likely a short-term aberration, Washington-based employers continue to bear the brunt of budget cuts and political brinkmanship. Although the budget has been passed and the shutdown proved to be ephemeral, haggling over the state of the federal government’s finances is far from over.

Near-term office outlook

The outlook for 2014 is for moderate improvement versus 2013. Many companies refrained from hiring in 2013 because of so much uncertainty. As this fog of uncertainty dissipates, particularly surrounding policy making in Washington, D.C., it should serve as a catalyst for hiring. We expect that the labor market, including the professional, managerial, technical and sales-related occupations that typically reside in office buildings, will improve throughout the year. Therefore, we anticipate that vacancy compression will increase modestly, to about 40 basis points.

Rent growth should continue to accelerate next year, rising by close to 3 percent on an asking rent basis and by over 3 percent on an effective rent basis. It has taken the economy and the office market years to claw their way back from the depths of the worst recession since the 1930s. 2014 is not likely to be the breakout year, but there are reasons to be more optimistic.

Brad Doremus is senior analyst, and Victor Calanog is head of research and economics, for New York-based research firm Reis.

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