Office Market analysis

Slow and Steady with Reis

Recent historical trends for office fundamentals have been relatively moribund. Vacancies stayed flat in 3Q2019, at 16.8 percent, while the national vacancy rate has been creeping upward since mid-2017. It is hard to foresee a situation where vacancies will drop in an accelerated — or even sustained — fashion over the next few years. Economic and demographic change, technological improvements allowing people to work remotely, and shifts in usage intensity of office space all contribute to the dampening of demand for this property type that led to a markedly slow recovery since the recession ended mid-2009.

Net absorption came in at 6.8 million sf in the third quarter, in line with quarterly patterns over the previous two years. This comes over a base of new completions that clocked in at 7 million sf. Comparatively speaking, this is lower than last quarter’s figure of 9.6 million sf, but higher than the 5.1 million sf added in 1Q2019, which was the lowest figure for new deliveries of single- and multitenant market rate office space in six years. This quarter’s figure falls below the quarterly average of 12.2 million sf added each quarter of 2018, which is consistent with the overall lack of developer enthusiasm for this property type. Office buildings are still being built, but they are concentrated in owner-occupied properties — often commissioned by tech firms in tech-heavy metros.

Developers’ Rational Expectations

With vacancies hovering at just 80 basis points below its cyclical peak of 17.6 percent in late 2010, there really isn’t much to stimulate building. Growth in asking and effective rents has been similarly muted, registering at 0.6 percent and 0.7 percent in 3Q2019. Developers are looking at other property types — like multifamily — and devoting resources there.

Office Net Absorption and Vacancy - Graph

On a year-over-year basis, asking and effective rents increased by 2.6 percent and 2.7 percent, respectively, which is in line with 2018 calendar year figures, and well below the 3.4 percent and 3.6 percent growth rates that the sector posted in 2015, a year that may well mark this property type’s cyclical peak in terms of rent growth.

With vacancies mostly flat and rent growth in the low to mid-2 percent range, it is no wonder that there hasn’t been much of a building boom for office properties over the last nine years. 

The office sector has been struggling with longer term trends that are prompting employers to rethink their need for office space (and what type they need). The rise of industries driven by technology and social media suggest that traditional office space formats, which tended to require more space, need to be reevaluated — perhaps less space for actual office equipment and more space for amenities that younger employees find desirable. The development of technology that allows workers to do their jobs remotely also bolsters the argument that perhaps employers don’t need to lease as much office space. Companies like WeWork position themselves at the forefront of “the new office space,” catering to the gig economy as it evolves. Beyond WeWork’s IPO struggles, a paper Reis published recently examines the effect of WeWork on nearby properties in New York City, to consider whether the coworking phenomenon has a measurable effect on rents and vacancies of nearby office and apartment buildings.

However, the jury is still out on which format and offering will prevail. In the meantime, the rate at which office space was built from 2003 to 2008 was about half that from 1997 to 2002, and it has slowed further in the current period of economic expansion.

Office Effective Rent Growth - Graph

Near Term Outlook

Reis does not expect the U.S. economy to grow by more than 2.0 percent to 2.2 percent this year, and this in itself is a slowdown relative to the 2.9 percent growth rate in 2018 that was a recent high watermark (the last comparable figure was in 2014). While you could argue that 2018 growth numbers were “sugar fueled” by the Tax Cuts and Jobs Act, any such boost in economic activity failed to materialize in stronger office fundamentals, so it is reasonable to expect flat to middling results for 2019. We have already seen this play out for most of the year.

This is not to say that there aren’t pockets of stronger office activity in specific markets, related either to relatively strong job growth or the presence of active, growing industries like tech. But in a world of relatively flat fundamentals, the gap between strong and weak metros tends to be larger; for example, office fundamentals in central business districts have been markedly stronger compared to suburban neighborhoods. This all argues for greater care and diligence when evaluating opportunities and risks for this property type.

Maybe slow and steady over 10 years is indeed better than a three-year boom followed by a massive pullback over the following decade.

Perhaps this is all for the best. If demand for office space is less than stellar, then why exacerbate the problem by overbuilding? Supply growth has been measured, and if we do run into any kind of economic downturn in the near term, it follows that office fundamentals will likely experience less distress. Maybe slow and steady over 10 years is indeed better than a three-year boom followed by a massive pullback over the following decade. It is worth noting that despite strong tech market activity over the last decade, San Francisco’s office rent levels have yet to achieve its historic highs from the year 2000 — almost two decades after the tech bust.

Victor Calanog, PhD, CRE

Victor Calanog, PhD, CRE is the chief economist and senior vice president at Moody's Analytics Reis.

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