Office

Stuck in Neutral

Office leasing can’t get up to speed.

A stubborn office market vacancy rate still hovers around 17.0 percent nationally in second quarter 2013, only marginally below its 17.6 percent peak in 2010. (See Reis sidebar, “The Numbers,” for a 2Q13 report.) This reflects the cautious attitude tenants still have about leasing office space.

“I’m currently working on a deal with a national tenant for roughly 13,000 square feet,” says Adam Palmer, CCIM, managing director of the office division for LandQuest Commercial in Fort Myers, Fla. “Negotiations are ongoing as they have been for nearly a year. While the market is improving, nearly all deals seem to take much longer to complete these days.”

Commercial real estate professionals who lease office space around the country report several factors that contribute to the slow office leasing market: tenants who examine every aspect of leasing office space, slightly improving markets burdened by too much space, and a new breed of landlords who can afford to discount rents.

The result? Space searches turn into marathons journeys, and lease negotiations drag on and on, as tenants — especially in secondary markets with loads of available office space — hem and haw and run the numbers once again.

Decisions, Decisions

Like Goldilocks, many tenants are looking for a space that’s not too big and not too small, but just right. “Tenants scour the market to learn about all the available options,” says Julie A. Johnson, CCIM, executive vice president of the Healthcare Investment Group at GPE Commercial Advisors in Phoenix. “I also see tenants interviewing landlords to understand their financial strength prior to entering a lease.”

In Phoenix and other markets, landlords are aggressively competing for tenants by lowering rents. The problem, Johnson says, is that low rents leave landlords little wiggle room for funding tenant improvements. “Tenants want to exhaust all options looking at existing, second-generation space that they can renovate [at a lower cost] rather than consider building out a shell space,” Johnson says. In a recent deal, the tenant extended the lease term by two years to give the landlord more time to amortize high TI expenses; the landlord agreed to amortize with no interest charge as well as include a termination and penalty clause if the tenant did vacate early — “all to incentivize the tenant to come to the property and maintain a competitive final lease rate.”

Justin Horwitz, senior adviser for Sperry Van Ness in Phoenix, agrees that it’s been tough finding tenants and landlords who can afford build-out costs on shell buildings. Tenants need the timeline and the desire for brand new space, he says,and “owners need to be extremely aggressive on the amount of money they will contribute to the improvements.” He’s completed several lease deals in the Rome Towers mixed-use development in Gilbert, Ariz., where the landlord contributed $60 per square foot in TI expenses. “Without that level of contribution, those deals would never have had a chance,” Horwitz says.

Indecision is also plaguing tenants in stronger markets, such as Charleston, S.C., where office leasing is rapidly improving, says Reid Davis, CCIM, SIOR, a principal with Lee & Associates in Charleston. “Competition for office space has re-entered the marketplace,” he says. “But the speed at which tenants make decisions has not changed.”

Charleston’s office market has picked up to the point where new construction has begun, Davis says, even a few speculative buildings, driven in part by Boeing’s decision to open an assembly factory in the area. “While activity is up in office leasing, most transactions still remain volatile until the very end and are viewed under a microscope by the decision makers,” Davis says. But some tenants are getting the message to lock in rates now: Rents have trended up for the first time in about six years.

Quality Over Quantity

Another way tenants are changing the game is through space use. “The biggest difference in this cycle is how people are using space,” says Wayne Shulman, CCIM, senior managing director, Newmark Grubb Knight Frank in Chicago. “The traditional office seems to be going out the door. Tenants of all kinds are looking for open office areas where people can collaborate. And workstation size is smaller so people can communicate more freely within a team or a division.”

Yet despite low rents, some tenants are only leasing the space that they need, Johnson says. “I see tenants preferring to work in a space where they may have less space than they need rather than more, just in case they shrink rather than grow in the near future.”

But in more robust energy- and tech-driven markets, where new construction has begun, what corporate America is giving up in quantity, it is looking for in quality, showing a distinct preference for new class A space, very little of which is available in many markets. While 7.6 million sf of new office product came online in 2Q13, the most since 2Q10, 1Q13 delivered only 2.2 million sf — the lowest amount since 1999, according to Reis.

There is near-record occupancy among most of Tulsa, Okla.’s better A class office properties, says Patrick Coates, CCIM, broker/owner of Coates Commercial Properties in Tulsa. “The class A office market is tight with only about 7.0 percent vacancy rate and rents have increased more than $1 psf for Tulsa’s existing class A office buildings,” he says. In addition, three new multitenant buildings went up in Tulsa this past year, adding more than 450,000 sf to the market, most of it already leased.

Recession Math

But the bid for quality over quantity exacerbates the rent growth struggle in many less-robust markets. Several large owner/occupant national headquarters are currently under construction near Green Bay, Wis., “representing the first substantial office expansion in a decade,” says Steve Seidl, CCIM, SIOR, of Seidl & Associates, in Green Bay. However, the vacated space will add to an already-oversupplied market where older class A space, much of it sold in foreclosure, gets a new coat of paint and new carpeting and comes back on the market at discounted rents. “These factors are driving rates in our suburban market into the $5 psf to $6 psf range,” Seidl says.

This post-recession math is hurting landlords who held on to their properties, adds Jerry Fiume, CCIM,account executive for NAI Cummins in Akron, Ohio, outside of Cleveland. “We are still leasing space for $12 psf NNN, which is about the same as we were charging 20 years ago. But build-out costs are about $45 psf to $50 psf now, versus $20 psf about 20 years ago.” It’s hard for the math to add up for landlords, he says, except for investors who bought properties for 30 cents on the dollar. “For everyone else, the recovery will take place when the market starts to support $18 psf NNN rental numbers,” he says.

Seidl considers another solution. “Until our supply diminishes, the office lease market will continue to struggle. Our market may reach a point where it is not overbuilt but underdemolished.”

Sara Drummond is executive editor of Commercial Investment Real Estate.

The Numbers: A Slow Recovery Continues

by Brad Doremus and Victor Calanog

With the labor market unable to generate significant office-using employment, demand for office space remains muted. The vacancy rate was unchanged during second quarter 2013 at 17.0 percent, a slight slowdown from the prior quarter’s 10 basis point decline. The pace of the office sector’s recovery has been very weak: On a year-over-year basis, the vacancy rate fell by just 30 bps. It is therefore unsurprising that national vacancies have declined only marginally since peaking at 17.6 percent in late 2010. National vacancies remain elevated at 450 bps above the sector’s cyclical low, recorded in the 3Q07 before the recession began that December.

Occupied stock increased by 7.2 million square feet in 2Q13. Much of this increase stemmed from the 7.6 million sf of office space that came online. Without this construction-driven absorption, same-store absorption figures indicate that there is little to no demand for space in existing buildings. At this point in the recovery, rental rates are still compressed across new versus existing space; combined with aggressive concession packages, tenants will tend to favor new buildings.

While comparatively modest by historical standards, having inventory increase by 7.6 million sf does support the notion of supply growth trending toward a more normal rate. The market has not delivered as much new space since the 2Q10 when many projects were completed only because they had been started before anyone fully grasped the magnitude of the Great Recession. Auspiciously, 2Q13’s increase in construction activity comes hot on the heels of last quarter’s 2.2 million sf of new office space, the lowest quarterly figure for new completions since Reis began publishing quarterly data in 1999. Most of the new space coming to market is significantly pre-leased, as is required for most developers to acquire financing in the current office property environment.

Asking and effective rents both grew by 0.4 percent during 2Q13. This increase is about par for the course since rents began rising consistently in 4Q10. Rents have now risen for 11 consecutive quarters, yet the cumulative growth for asking and effective rents during this recovery period is only 4.7 percent and 5.4 percent, respectively. For comparison’s sake, the office market is able to produce that kind of rent growth in typical calendar-year periods. Rents remain below peak levels set in 2008, and without stronger gross domestic product growth and more robust job creation figures, it will take years to return to those levels.

Looking Forward

We remain cautious about the remainder of 2013. There is some optimism given the underlying resurgence in the economy that the labor market will not experience the midyear swoon that we have seen in the last few years. However, the headwinds from fiscal policy due to both increased taxes and sequestration have been putting the brakes on the labor market recovery in recent months: Year-to-date job growth is actually running behind the comparable period from 2012.

Economic activity outside of the U.S. will not provide a panacea in the short term. Slowing economic expansion in Asia, particularly China, is expected to continue to exert a drag on worldwide economic growth. Near-term relief from European markets is also not expected as many Western and Central European economies are still struggling with the combined impact of high unemployment, bad debt, and the ramifications of their government austerity programs.

These headwinds are likely to persist until at least late this year as the economy fully digests domestic fiscal policy changes and subpar economic activity outside our borders. With full sequestration initiated this quarter, married with higher taxes from the first quarter and the specter of higher interest rates for the remainder of the year, job growth for 2013 is now expected to be slightly below 2012. We expect office vacancies to descend very slowly, ending the year at just below 17.0 percent, and asking and effective rent growth to be below 3.0 percent.

Brad Doremus is senior analyst and Victor Calanog is head of research and economics for New York-based research firm Reis.