West Coast Equity Group

U.S. Commercial Real Estate Market Update – Office, October 2015

Public perception has generally been that activity is weakening in the Commercial Office Real Estate market, but according to Walter Page, Director of Research at the Costar Group — the commercial real estate industry’s leading provider of information and analytics — the Office market is actually booming right now. Page provided a 2015 market update at the Commercial Real Estate Show podcast on October 14th.

MARKET SUMMARY

The commercial office market is tightening up and rents are increasing overall on a national level. This trend seems to defy logic given that more employees are working remotely, companies are allocating less office space to employees, and the U.S. economic recovery has generally been a “jobless” one. Despite these trends, the office market is performing extremely well and the forecast is for continued demand, decreasing vacancy rates and further growth in rents. Current trends include a continued reduction in space per employee to 235 SF (down 10% since 15 years ago), and a “flight to quality” with three times the demand happening in Class A office space vs. Class B and C office. There is also a preference for open and collaborative work spaces in buildings constructed since 2000.

2015 YTD OFFICE MARKET PERFORMANCE

Overall, the commercial office market is performing exceptionally well right now in the U.S. Below are the key indicators.

  • Vacancy rates are down to 11%, having declined 20 basis points vs. last quarter, and 60 basis points vs. one year ago.
  • We have now experienced 5 years of declining vacancies in a row, and we’re close to achieving parity with pre-recession occupancy levels not seen since 2005.
  • Rent growth in the office category is 4.3% which is considered extremely strong. As a comparison point, one year ago at this time, rent growth was 3.8%. This is a very strong number especially when you consider that inflation is currently averaging 1.7% in all markets, according to 2015 Costar data.
  • Further validating the increased competition for office space is a “burn off” of free rent concessions.
  • Central Business Districts (CBDs) in gateway markets like San Francisco are seeing exceptionally strong growth. San Francisco continues to top the chart with 19% in rent growth year over year for the past 5 successive years, followed by San Jose, and the East Bay Area. Other strong markets include Denver’s CBD with 9.4% year over year, Seattle with 7.5%, New York City at 5.8%, and Miami with 5.4% in rent growth. The trailing markets are Washington DC and Houston.
  • Demand for space is currently very strong on a national level, in both gateway market CBDs as well as suburban markets. Overall, the office market has seen 30M SF of net absorption of space in the past quarter and has reached 101M SF of net absorption of space in the past year. The last time we saw demand this strong was in 2007, just prior to the Great Recession. This is a rate of demand growth of approximately 1.4% which is a pretty good number, especially given that the national job growth number is closer to 2% which indicates that there could be even more demand growth in the future.
  • In terms of sales, market volume is currently at $92B in sales YTD for 2015, the highest it’s ever been in the first 3 quarters was $117B and that included nearly $60B accounted for in equity office, so the reality is sales volume today absent a single mass of transactions is exceptionally high.

COMMERCIAL OFFICE MARKET CONSTRUCTION UPDATE

  • YTD in 2015, the U.S. market currently has 15M SF of space delivered, or roughly half the rate of net absorption, and there is currently 128M SF of new space under construction, up 14% compared to a year ago. Roughly half the markets in the country now have a significant level of new construction underway.
  • Vacancy rates in newer construction buildings (buildings constructed since 2000), have a vacancy rate below the national average. This doesn’t normally happen because of new construction coming on to the market, but when it does, it is an indication that there is a shortage of inventory which also indicates that continued new construction investments are low risk.
  • Primary demand is for Class A office space which is growing at 3 times the rate of both Class B and C office space. Currently, the U.S. is seeing a 2.5% growth rate in Class A office space vs. 0.8% growth in Class B and C office space. This is a clear indicator of a “flight to quality” trend which is very strong at the moment. Some reasons to explain this include an assumption that if the amount of space available to employees is decreasing, it makes sense to put them into higher quality, more modern work spaces and the fact that nicer office spaces help retain and recruit higher quality workers.

GROWTH NOT JUST OCCURRING IN CENTRAL BUSINESS DISTRICTS

  • While much growth has occurred in the gateway market CBDs, there is also tremendous growth now in the suburban markets.
  • YTD the U.S. market has absorbed 10M SF of space in the CBDs which represents an annual rate of absorption of about .7%.
  • Suburban markets by comparison have absorbed four times that amount of space and absorption rates are growing at double the rate (1.3%).
  • The demand in suburban markets is strongest in markets close-in to the CBDs, indicating that many companies are getting priced out of the CBDs and seeking more affordable options in nearby markets.

COSTAR’S FORECAST FOR THE NEXT FEW YEARS

  • Vacancy rates will continue to decline to the 10.5%-10.3% range, likely bottoming out in 2017 depending on location.
  • Rent growth will moderate, especially in markets with significant new construction underway. Costar’s expectation is that rent growth with remain in the 2.5%-3% range overall for the next few years, which is still well above national inflation currently averaging 1.7% for the U.S. as a whole.
  • Further compression is expected (an additional .5 % per year in compression).

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