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Recovering Office Demand Sets Stage For Rent Growth Across The U.S.

2012 Mirrored Every Bit The Sluggish Recovery That CoStar Economists Predicted, But There Were a Few Surprises Along The Way
January 30, 2013
Tenant demand for office space ended 2012 on a strong note as occupancy gains spread across a broadening array of U.S. markets, opening the door for widespread rental rate increases this year, CoStar Group reported in the company's Year-End 2012 Office Review & Outlook.

While overall leasing volume appeared to be somewhat lower in 2012 from the previous year, strong absorption and very limited new construction -- combined with a significant number of demolitions/removals of antiquated buildings -- helped to push the U.S. office vacancy rate down 50 basis points over the past year to 12.3% at the end of fourth-quarter 2012, according to CoStar analysts.

In the fourth quarter, tenants absorbed a net 24 million square feet of space, for a total of 59 million square feet of net absorption for the year. The figure is slightly less than CoStar originally forecast but very strong compared to 2011, which rallied from a very slow first half to post 41 million square feet.

Nearly every U.S. office market enjoyed absorption gains in 2012, with the exception of a few markets with industry-specific or regional economic issues, such as Northern New Jersey, where the pharmaceutical business has been in contraction.

Joining perennially strong markets such as Houston and Dallas-Fort Worth in full recovery were the former housing-bust metros of Phoenix, Atlanta and Orange County, CA, where the local economies have benefited from increased office hiring and a gradually improving housing market.

"Submarkets such as Atlanta’s Buckhead, which were overbuilt, are now seeing increasing occupancies," said Walter Page, Director of Research - Office, who was joined by Managing Director Hans Nordby and Manager, U.S. Market Research Aaron Jodka in analyzing the fourth-quarter and annual data. "The makings of rent growth are now in place in these markets."

Absorption numbers show that companies are adjusting their decisions on where to lease space based on local employment, economic and regulatory conditions, Nordby noted.

"The big absorption office markets are energy and tech based, and tend to be in low regulation, low tax states. The markets with the highest regulation and cost structures are the most sclerotic," he said.

With very limited new office construction save for medical office and health care related projects in various markets and a significant amount of older space claimed by the wrecking ball or converted to other uses such as multifamily or hotels, vacancy rates fell across the country in the fourth quarter.

For example, Phoenix, which has led the nation in occupancy gains over the past year, saw its vacancy rate decline an additional 90 bps in the fourth quarter, finally dipping below 20%, Jodka said. Most of the top markets are seeing strong occupancy gains, meaning that landlords may soon finally begin to envision raising the rent.

"A lot of markets are now in that 11%-12% vacancy rate range," Page said. "That’s the long-term average vacancy rate, and when [markets] drop below that level, you are moving into the territory of rent growth."

Deliveries are expected to remain significantly below the rate of net absorption through 2015 and much more occupancy growth is on the way, Page predicted. In fact, the office sector is the only property type that will see a more than 1 percentage point improvement in average occupancy rates going forward, and that’s a good sign for office investors as rising rents, values and returns follow.

Rent growth rose 1.7% year over year in 2012 and still moving upward. CoStar projects that average growth will reach 3% next year, but more importantly, rising rents will spread to more markets as limited supply is absorbed.

Another key metric, the number of CoStar office submarkets experiencing declining vacancy rates, exceeded 50% in the fourth quarter -- the highest since the peak of last boom cycle.

While CBD markets were the first to recover and have seen the largest declines in vacancy, the best-of-the best "premier" suburban office submarkets have also enjoyed a remarkably fast recovery, especially over the last six quarters, Nordby said.

Next in line to reap the benefits of absorption and occupancy growth are the nation's long suffering secondary and tertiary markets, which typically don’t get much of a look by developers.

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