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Spec Development Returning In Hottest U.S. Office Markets

CoStar Analysts Say Projects Without Signed Tenants Will Move Forward In A Growing Array of Metros In Coming Quarters
July 25, 2014
Cranes are once again dotting the skylines of select U.S. cities as office construction, fueled by rising rents and strengthening demand in the improved economy, finally awakens from a six-year slumber.

Unlike the scattered build-to-suit projects that marked the early office recovery, lenders and investors are again rolling the dice on speculative ventures in a handful of large metros, including San Francisco, San Jose, Boston, Austin, New York -- and especially, Houston.

Spec deals are trending upward across the country as rising rents and receding supply justify new projects. Year-over-year office rent growth held steady at 3.7% in the second quarter, matching the first quarter for the largest increase of the recovery so far, according to data analyzed by CoStar Portfolio Strategy.

Editor's note: For a comprehensive look at the U.S. office market halfway through the year, view the CoStar State of the Office Market Mid-Year 2014 Review & Forecast. CoStar subscribers may log on and click the Knowledge Center tab.

Project deliveries increased by nearly 20% to 47 million square feet over the past four quarters versus a year earlier. Under-construction volumes have jumped more than 38% over year-end 2013 levels to 65.4 million square feet through the second quarter, with the top 10 markets representing almost 70% of total development activity, according to JLL’s Midyear 2014 Office Outlook.

However, unlike in past cycles, no one is worried about over-building.

"This is by no means a spec-driven supply wave to be concerned about" from an overbuilding standpoint, noted Aaron Jodka, manager of U.S. market research for CoStar Portfolio Strategy.

"Spec is no longer a four-letter word in the office markets where rents justify construction. The issue is, there are only a handful of markets where that’s the case," Jodka added.

Tech Spec Gone Wild

Strong leasing and development in Houston and the San Francisco Bay Area reflect the demand growth by booming technology and energy companies in those and other core markets, noted John Sikaitis, managing director of research at JLL.

Most notably, in April signed the largest lease in San Francisco history, taking 714,000 square feet at 415 Mission Street, formerly dubbed the TransBay Tower, now Salesforce Tower. The high-rise under development by Boston Properties will be the tallest building on the West Coast when completed in 2017. Tishman Speyer and Kilroy Realty Corp. are also building spec office high rises in the South of Market and Financial Districts.

In Houston, more than 15 million square feet of new office space is under construction, including a number of speculative projects - by far the most of any U.S. city. Campuses for major energy companies such as AirLiquide and Phillips 66 are along the burst of spec and build-to-suit activity.

Deliveries in the first half of 2014 have likewise remained concentrated in a few markets, including New York City, Boston, Dallas and Washington, D.C. CoStar expects development to fan out into other markets in coming quarters, including Los Angeles, Kansas City, Charlotte and Minneapolis.

REITs Driving CBD Development

With acquisition opportunities limited, "many [REIT] management teams have planted seeds for future growth through redevelopment, development and accretive re-financings," noted Citi REIT analyst Michael Bilerman, pointing to a recent Citi survey showing almost half of REIT CEOs prefer to "build over buy."

At this point, however, the "bull case" for REITs prevails, with new supply remaining low versus history, helping fuel growth in existing assets. Flowing debt and equity capital will continue to drive strong pricing, Bilerman in a recent research note.

A sudden increase in development, however, could dampen operating fundamentals and lead to weakness, Bilerman said in corresponding list of potential "bear case" risk factors.

While concentrated in their existing markets, office REIT growth is mostly driven by new development, and executive teams are "being more prudent than in past cycles and looking for solid pre-leasing before breaking ground," said Citi REIT analyst Emmanuel Korchman.

But the value proposition in moving dirt is becoming clearer. CoStar's Jodka said office REITs, similar to apartment companies earlier in the recovery, are finding higher yields on building versus acquiring assets as prices rise in prime markets.

"It makes sense to push forward if REITs have development sites ready to go, as new supply should entice tenants."

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