Investors Have Cause to Celebrate Gains in 2013 as Office Recovery Hits Only the Halfway Point
Investors are cheering the gains in asset values seen during 2013 from a strengthening recovery in the U.S. office market, and looking forward to an even brighter 2014 as virtually all the important metrics that drive rent growth and property income are expected to continue to improve over the next 12 months.
The robust office market performance was the highlight of the year-in-review analysis and forecast webinar presented by CoStar market experts Walter Page, director of office research; Hans Nordby, managing director and corporate officer, and Aaron Jodka, manager, U.S. market research.
According to CoStar's analysis, net absorption in the U.S. office market rose a solid 22% in 2013 over the previous year to 59 million square feet, with the increased demand helping push the vacancy rate down 50 basis points from 12.4% to 11.9%.
The growing demand for office space, combined with an extended period which has seen little to no new office construction, resulted in the average U.S. office rent to grow 3.1% last year - the first time rents have cracked the 3% annual growth mark since 2007, the peak of the market cycle.
New office construction remains muted with just 40 million square feet of new office space added in 2013, and another 78 million square feet under construction at the end of December. Any gains in construction were largely offset by the loss of existing office space as older buildings were demolished or converted, in many cases to be replaced with apartment or condominium properties.
Despite a flattening yield curve and expectations that 10-Year Treasurys will rise to nearly 5% over the next few years, investors increased office purchases by 20% last year, for total office property sales of $106.2 billion, driven in part by demand created by the 2.4% gain in office-using employment in 2013, well above the overall U.S. employment growth rate of 1.6%.
Looking ahead, the CoStar analysts expect the country should finally reach its pre-recession employment peak by summer 2014, building on the 750,000 new office-using jobs gained in 2013.
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The office recovery continues to evolve and broaden in new and different directions. While CBD markets in top-tier gateway markets saw the lion's share of improvement earlier in the recovery, suburban office is now recovering at a dramatic rate, driven by gains in technology, health care, education and even energy industry jobs.
"Markets such as Charlotte are being driven by diversifying economies and lower business costs. Many of the jobs coming into the office sector such as call centers don’t use CBD towers, but they do absorb space," Nordby said. "This is one of the few calls we've been on where it's hard to find much bad news at all."
Vacancies Down, Rents Up
In fact, the CoStar analysts said, 2013 was a great year for the office market. Even better, the office recovery is only at about the halfway point -- the vacancy rate is expected to plummet another 100 bps to 10.9% by the end of 2015, noted Page, adding that the 59 million square feet of net absorption included a strong year-ending 20 million square feet in the fourth quarter.
"For office investors in particular, the second half of this recovery is what they like," Page said. "With the occupancy gains, we should see rent, NOI and value gains.
"We are reaching what I’d call a sweet spot -- and we’re also reaching a tipping point, the 11.6% vacancy line which is the historical average between 2004 and 2012," Page added. "At that point, we will really see accelerating rents."
Roughly half of major markets have already reached or are near that point, including Pittsburgh (8.2%) New York City (8.8%), San Francisco (9.3%) and even St. Louis (11.6%). Baltimore (11.6%) and Philadelphia (11.7%).
Not reflected in the hard numbers is the decline in free rent and concessions offered by landlords, which have been cut in half in such markets like Seattle, Boston and Miami. Rent discounts tenant improvement packages are also shrinking in many markets, Page said.
While the majority of U.S. office markets experienced notable gains, others still have a ways to go. Detroit and Phoenix still have vacancy rates of 17.9% and 18.2%, respectively, but they’ve also come down from stratospheric levels.
The Amazing Suburban Office Rebound
While suburban office markets were still largely lackluster as recently as a year or two ago, CoStar analysts now describe the recovery in the suburban office sector using superlatives such as amazing, remarkable and "on fire."
Lingering higher vacancies have prevented additional construction in many suburbs, which are also benefitting from the fast-growing tech, health-care and other employment sectors. Suburban markets, which make up a much higher share of total office inventory than CBD markets, account for 90% of total office absorption.
"Some of the recovering suburban markets would have been in tough shape a year, 18 months ago," Nordby said. "The economy has become much more broad-based, and normal, low-cost back-office places like Tampa and Phoenix have been posting very good job growth."
Cranes Rising In More Markets
While office construction starts remain low as a percentage of existing inventories, building has been relatively brisk in a few markets like San Jose, Austin, Houston and Boston -- and more recently, San Francisco, Dallas, Northern New Jersey and even Chicago.
Most projects are built with tenants or owners in tow, although developers are beginning to move forward on a handful of speculative projects. It's hardly a surprise to see cranes piercing the skyline in San Francisco, where 2.5 million square feet is under construction, including Jay Paul Co.'s 181 Fremont, a $500 million mixed-use tower in the South Financial District with 415,000 square feet of speculative office space.
San Francisco CBD rents have risen 63% from their recession lows, compared with average 5.7% rent growth for the 54 largest markets.
"Much of this activity is smart money getting under way before the cycle becomes long in the tooth, and we’ll see more of this across the country," Nordby said.