Office Rents At A Tipping Point?

Although rising levels of office absorption and a falling U.S. vacancy rate signal a strengthening market, the gains have yet to translate into meaningful rent increases for office landlords in most markets, CoStar Group reported this week in the company’s Second-Quarter 2012 Office Review & Outlook.This week, CoStar analysts drilled deeper into the office market numbers in a report on the national office market at midyear 2012 presented to CoStar clients. And while they see encouraging signs in the broader CRE market, specifically in the office and industrial sectors, they cautioned that the recovery is likely to be slow and dependent on the rate of job growth.”Overall for the office market in terms of demand, it’s a pretty good story,” said Hans Nordby, managing director of Property and Portfolio Research (PPR), CoStar’s analytics and forecasting division. Nordby was joined by Walter Page, PPR director of research; and Jay Spivey, CoStar senior director of research and analytics.

Although office job growth slowed on a year-over-year basis to 1.9% from last quarter’s 2.8%, it’s still growing at a much stronger rate than the broader U.S. economy, which remains a nagging source of concern to economists.

Office job growth is the life’s blood of real estate fundamentals. And those fundamentals are starting to pick up momentum, with net absorption of U.S. office space more than doubling from 8 million square feet in the first quarter to 18 million square feet in the second quarter of 2012. Despite the surge in absorption “it’s still not a screamer of a quarter” compared to the boom years of 2005 and 2006, Nordby noted.

Net absorption over the last year has totaled about 63 million square feet, translating to a 0.9% rate of growth in office demand, roughly half the rate of office job growth, Page noted. Houston, the nation’s top energy market, led the nation in absorption growth at 3.1 million square feet of net absorption. The long-suffering Atlanta market is starting to show significant demand growth.

At the other end of the spectrum, the pullback by pharmaceutical and insurance companies has resulted in modest negative absorption in a handful of markets such as Northern New Jersey and St. Louis.

The office market is now reaping the benefits of job creation a year ago, especially in markets such as San Francisco, New York, Minneapolis and Detroit. Other sectors such as financial services and entertainment are starting to show job gains, nudging markets such as Orange County, CA into a stronger recovery.

The vacancy rate fell slightly by 20 basis points to 12.6% in the second quarter from the previous quarter, and is down 70 bps from a year ago. The slow rate of net absorption compared with the growth in office jobs is due to the shadow space from the high levels of job losses during the past recession without a corresponding loss of office demand. In short, tenants are burning off excess space that is left over from the recession, before the need to lease additional space will be realized.

Demand remains concentrated in top-tier 4- and 5-star buildings, achieving nearly double their fair share of absorption of tenants take the opportunity to move up to higher-quality buildings, Page said. As the recovery gains momentum and little new office supply on the horizon, absorption is spreading into lower-grade buildings, he said.

Gross leasing totaled roughly 95 million square feet per quarter between 2006 and 2009, a number that has shot up to 125 million square feet on average during the last three years as tenants have sought to upgrade their space, Spivey said. The 30% increase in leasing dovetails with a 10% decline in rents.

This year, deliveries of new office space as a percentage of inventory will total just 0.6%, far lower than the 30-year average of just over 2%, Spivey said.

Don’t look for anything to change soon on the supply front. With no real uptick in construction starts, the office market is still 3-4 years away from achieving significant new supply, with the scant level of new construction tending to be highly preleased.

The higher absorption and lower vacancy has yet to translate into meaningful year-to-date gains in rents, which are up only 0.7% from the same time last year, much of that driven by a 1.6% hike in Class A rents. The prospect of future vacancy declines suggests that the scales are tipping toward positive office rent growth, but growth has been underwhelming as of the end of the second quarter of 2012.

However, face rents move much more slowly than effective rents, as evidenced by landlords who are starting to pull back from rent concession, tenant improvement allowances and other tenant perks in top markets around the country, Nordby said.

While government spending driven markets such as Washington, D.C. posted the strongest rent increases five years ago, technology and energy based markets such as San Jose and Houston are now leading the charge.

Office investment sales are at roughly the same level as the first half of 2011, however, sales volume has spilled beyond the top five U.S. markets into secondary markets with lower barriers to entry for new supply.  (credit R. Drummer: Co-Star)

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