Office leasing could use a charge in smaller markets.
The recovery in the office market has been painfully slow in the majority of metros across the U.S. But a strengthening economy and more robust job growth could give the office sector a much needed charge in the year ahead.
Even the most seasoned brokers are growing tired of the pace of leasing activity where weak demand for space is the new market norm. Vacancies have been inching lower with a national average that improved to 16.7 percent in fourth quarter 2014, according to data from New York-based Reis Inc. Although that figure marks the lowest level since 3Q 2009, the year-over-year vacancy declined only 20 basis points.
Positive Signs
Nevertheless, there are some positive signs in both the broader economy and the office market that fundamentals are poised for a bigger leap forward this year. “I think you will see the market gain traction over the next couple of years,” says Ryan Severino, senior economist and director of research at Reis. Gross domestic product growth has been surging of late with an annualized 5 percent growth rate during the 3Q14, which is the highest rate since 2003. Last year also marked the biggest year of job growth in more than a decade. Job growth averaged 246,000 per month in 2014 compared with an average monthly gain of 194,000 in 2013, according to the Bureau of Labor Statistics.
The U.S. is finally getting to that stage where improvement in the labor market is going to start translating into greater demand for office space, Severino adds. To that point, nearly 11 million square feet of net absorption in 4Q14 was the highest level since the 3Q 2007, according to Reis. In addition, there is still very little office development by historical standards. That should mean great compression in vacancies and more acceleration in rent growth in 2015 and 2016, he says.
During the past seven years, many companies have made do with the space they had, perhaps extending in place in exchange for rent reductions or concessions. Other tenants were motivated to downsize or took advantage of competitive pricing to upgrade space for a comparable or reduced rent. “We have seen a lot of tenants move from one building to another to save 50 cents or a dollar per square foot,” says N. Justin Cazana, CCIM, a principal and broker at Cushman & Wakefield Cornerstone in Knoxville, Tenn.
To some extent, that is still occurring. But more companies also are shifting into expansion mode. In January, Cazana closed a lease deal for one Knoxville tenant that relocated to a newer 27,000-sf space in a class A building. The new space is about 60 percent larger than the firm’s previous location. “This was one of the first deals where a tenant is actually expanding in the market,” Cazana says. He is working with two other clients that are both looking for about 20,000 sf of new space, and Knoxville also is on the short list for two new call centers. “So the activity lately has really been exciting,” he says.
Uneven Recovery Persists
Although the forecast for more improvement ahead in 2015 is welcome news, the recovery is by no means equal in markets across the country. “We are at a point in the cycle now where the tide has raised all ships,” Severino says. The economic recovery has created stability and slight improvement in the office market. In 2014, only one out of the top 79 markets in the U.S. did not report positive effective rent growth, according to Reis.
However, there is a very large gap between the strong markets that have led the recovery and the rest of the metros that have lagged behind. Of the top 79 metros that Reis tracks, only 10 have seen effective rents grow above 3.5 percent in the past 12 months. Effective rent growth in the vast majority of markets is at or below inflation. The “haves” are clearly those markets that have been buoyed by tech and energy, such as San Francisco, San Jose, Calif., Houston, and Dallas, as well as major metros such as Boston and New York. San Diego, Orange County, Calif., Denver, and Seattle also are experiencing growth. “Outside of those market areas, it is still a very tepid recovery at this point,” Severino says.
Markets that rely on oil, gas, or technology have been outperforming the national average and that has certainly been the case in cities such as Tulsa, Okla. Although the local economy has a strong manufacturing base, the office market has been buoyed in recent years by the demand for space, particularly class A space, from oil and gas companies. “Over the past five years, there has been a flight to quality, because times were good,” says Patrick Coates, CCIM, managing broker and owner of Coates Commercial Properties in Tulsa.
The Tulsa market, which is home to nearly 23 million sf, has been very active recently. The class A office market currently has a vacancy rate of about 5 percent. In fact, the diminished supply of class A space has sparked new construction. Two multistory office buildings ranging in size between 60,000 and 80,000 sf were built in the past two years in the south Tulsa suburban market.
The city’s class B office space has a somewhat different story with large pockets of vacancy, especially among the older buildings in east Tulsa. The B-plus buildings are fairly full, while the B, B-minus, and C buildings are struggling with vacancies that might range from 18 to 30 percent, notes Coates. The class B buildings in downtown Tulsa are faring better due to some of the downtown improvements that have occurred. The area has seen investment in the form of converting older warehouse properties into museums, office, and retail space; a hotel; several new restaurants; and streetscape improvements. “Our downtown has really exploded over the last three years,” he says.
Tertiary Markets Still Struggle
Recovery is slower in many tertiary markets across the country. “There is a very low demand for office space in our market, and our vacancy rates are going up a little bit,” says Douglas M. Erickson, CCIM, a broker at Coldwell Banker Commercial SoundVest Properties in Rockland, Maine. Erickson covers the mid-coast area of Maine, which is home to about 114,000 people.
Maine overall is about 16 to 18 months behind the national trend in terms of economic recovery, Erickson says. Portland, Maine, seems to be a little bit busier, but growth has yet to trickle down to the towns situated in the mid-coast area, he says.
The mid-coast market is driven largely by its existing business base. “Right now, although we have a very good job market, we’re not finding new companies coming into the area for a number of reasons,” he says. Erickson predicts that it will take another year to 15 months to fill the excess supply of space due to the low demand.
Erickson adds that existing office tenants are still downsizing to some extent, particularly in the healthcare sector where some physicians and medical services are relocating to be closer to the main hospital in Portland. Companies across the board are being cautious about expansion and new growth, while some are also choosing to stay put in existing spaces and renegotiate lower rents. In two recent lease deals, it took Erickson nearly a year to find a tenant to occupy a 6,500-sf space and about five months to fill a 5,000-sf vacancy. “It is slowly coming, but it is going to take a little bit more time to catch up with the national trend,” he says.
Leasing Activity Returns
The gap between the “haves” and the “have nots” is expected to narrow in 2015 as the economic recovery continues to expand beyond energy and tech sectors. The drop in oil prices also will temper the rapid growth in some markets such as Dallas and Houston, at least in the short term.
Many metros have already started to see an uptick in leasing activity. During the latter half of 2014, tenants started making decisions again, says Terri Dean, CCIM, a broker/senior director and vice president of operations at Sperry Van Ness Avat Realty in Huntsville, Ala. Huntsville weathered the recession better than many metros, but the city was hit by government sequestration in 2013.
Huntsville has a strong concentration of government contractors related to NASA and the Redstone Arsenal, and sequestration created a lot of uncertainty in the market among civil companies. “They were cautious about renewing leases and renting spaces, because they weren’t sure if they were going to get any more contracts,” Dean says.
Although leasing activity is returning, tenants are still being cautious and making smart decisions about what they lease, she adds. Companies in general are just leasing the space they need and not accounting for future growth. “It is harder to lease the really big spaces, but it is moving again,” she adds. The office vacancy in Huntsville declined to 12.1 percent in 4Q14, which is down 70 basis points compared to a year ago.
Leasing in the Knoxville market started to pick up in 2013 and that activity ramped up over the last half of 2014. “People are a lot more confident in the Knoxville economy and in how the national economy is running. Businesses are taking advantage of what they see in stock markets and employment and trying to really position themselves for the next decade,” Cazana says. Some tenants are making a move because of market timing. They believe now may be, potentially, their last opportunity to take advantage of a soft market. Several submarkets in Knoxville are still overbuilt, which allows tenants to find an ideal location in a class A building with some incentives in place, he adds.
In Knoxville, landlords remain aggressive in both the CBD and major suburban submarkets. Tenants are looking for leases with turnkey construction and in many cases they are getting it, especially for spaces that are 15,000 sf or bigger, Cazana says. Although rent bumps will be significant over the long term, initial rents are still low and six months of free rent is not uncommon. “It is still a tenant-friendly market, but that is starting to change,” he says. “This absorption is starting to really get a lot of traction and it won’t be long before landlords will start getting a little more leverage in negotiations.”
Backfilling “B” Space
Some markets are seeing a “flight to quality” with tenants exhibiting a greater appetite for newer class A space, while older class B space remains a tough sell.
Case in point is Kansas City, Mo., where the class A-plus market has improved significantly. “Without much speculative development, there is a scarcity for premium space,” says Brent Roberts, CCIM, a first vice president at CBRE Group in Kansas City, Mo. “If you’re a 20,000-square-foot tenant you don’t have any choices in that product type right now.”
In contrast, the class B market has seen little movement in the vacancy rate or increase in lease rates, Roberts adds. “We have some larger chunks of B space in our market that have been vacant for many years,” he says. Even though that space may be significantly cheaper than doing a build-to-suit, some B owners just have a hard time attracting the right tenants, he adds.
Typically, class A space tends to lead the market recovery. But that is not necessarily true of the current cycle. “Even class A property has not had much of a recovery up until this point,” says Ryan Severino, senior economist and director of research at Reis Inc. That slow rebound in the class A market will likely mean an even longer road to recovery for older class B and class C properties that often struggle to compete with the features, infrastructure, and amenities of newer class A buildings.
According to Reis, class A vacancies have declined from a high of 16.8 percent in 2010 to hover at 15.4 percent for much of 2014. In contrast, class B/C vacancies have remained relatively flat for the last few years. At the beginning of fourth quarter 2014, class B/C vacancies were at 18.3 percent — a slight 20 basis point improvement over 2010.
By national standards, Huntsville, Ala., has a modest vacancy rate at 12.1 percent. However, that still translates to 2.3 million sf of empty space, which is a heavy load for the MSA of 450,000 people. Landlords, particularly among the B and C buildings, are reducing rents and offering incentives such as more tenant improvement dollars to attract tenants, notes Terri Dean, CCIM, a broker/senior director and vice president of operations at Sperry Van Ness Avat Realty in Huntsville, Ala.
Some owners are choosing alternative ways to recycle that empty space with conversions to other uses such as condos or apartments. For example, Huntsville-based Intergraph built a new 250,000-sf headquarters on its existing 300-acre campus that was completed last fall. The company has decided to redevelop much of the older space it vacated into a larger mixed-use project that will include office, retail, entertainment, and residential space. “They saw that with as much space as they had, there was no way they were going to be able to reuse that as office space,” says Dean.
By: Beth Mattson-Teig (Commercial Investment Real Estate)
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