Office Property Vacancy Rates Still Slowly Declining

The national vacancy rate for the office sector fell to 16.8 percent in the second quarter, a 10 basis point decline over the first quarter of the year. …

The national vacancy rate for the office sector fell to 16.8 percent in the second quarter, a 10 basis point decline over the first quarter of the year. This is in line with trends witnessed over the last three and a half years. Vacancies peaked at 17.6 percent in late 2010, and since then any recorded declines were no larger than 10 basis points. It has certainly been a slow recovery, but quite in line with expectations, given an economy that has been growing at an average of 2 percent per year since the end of the recession.

On a slightly positive note, net absorption registered its highest quarterly increase since late 2007, with occupied stock rising by 9.8 million sq. ft. This compares favorably with the quarterly average of 7.1 million sq. ft. in 2013. Supply growth was similar to quarterly averages during 2013, with 6.3 million sq. ft. of office space coming on-line. This spike in net absorption (however minimal), paired with constant supply growth, hints at increasing demand for both existing inventory and newly completed space. Last year, tenants preferred newly developed space—with absorption patterns more clearly tied to new buildings coming on-line with pre-leasing commitments. If net absorption continues to outpace completions over the course of 2014, vacancy declines should be more pronounced.

Great expectations?

The key to improved net absorption remains the labor market—more jobs, and higher quality jobs, are critical to supporting stronger demand. Supply should remain largely in check, constrained by the pre-leasing requirements necessary to obtain construction financing. Very little, if any, speculative development is occurring in today’s market.

Reis expects U.S. GDP to rebound from a weak first quarter and post annual growth in the mid-2 percent range in 2014. While this is hardly spectacular, it does imply a slightly faster growth rate than the U.S. economy’s long-term growth potential of 2.1 to 2.3 percent. This should translate to roughly 200,000 to 250,000 jobs created per month, and slightly greater demand for office space. So far this year, job growth has fallen in line with our projections. The 217,000 jobs added in May marked the fourth consecutive month of payroll additions topping 200,000, bringing the year-to-date monthly average to more than 213,000 jobs, a decidedly positive sign for the economy.

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What about rents?

Asking and effective rents grew by 0.7 percent and 0.8 percent respectively during the first quarter. While these increases appear minimal, rent growth over the past three years shows an improving trend. Rents have now risen for 14 consecutive quarters; asking rents grew by 1.6 percent in 2011, 1.8 percent in 2012, and 2.1 percent in 2013. Landlords appear to have little leverage over tenants, with concession packages being pulled back very slowly—effective rent growth is not much faster than asking rent growth. As demand for office space accelerates this year, we should expect concessions to decline, with effective rent growth outpacing asking rent growth.

But by how much will rent growth accelerate this year? Reis’s 33-year rent and vacancy time series provides an answer: national vacancies will have to fall below 14 percent before we see rent growth of 3.5 percent or higher. Nevertheless, we expect a slight acceleration in demand for office space—and rent growth—in 2014, in line with faster economic growth and a healthier job market.

Market highlights

With national vacancies declining by only 10 basis points, it should not be surprising that roughly half of Reis’ top 82 markets posted slight improvements in vacancy levels, with the other half posting flat or declining occupancy rates. Performance at the metro level generally reflects the pace of improvement of the real economy, with wide variations across markets. The technology and energy sectors continue to drive the creation of higher paying jobs, and office market performance reflects this. This quarter, eight of the top 10 markets ranked by effective rent growth have a meaningful technology or energy sector presence. They include San Jose, San Francisco, Dallas, Houston, New York, Austin, Seattle, and Oklahoma City.

In the seesaw battle for the tightest office market, Washington, DC reclaimed the title (as measured by lowest vacancy rate) from New York with a 9.7 percent vacancy rate at the end of the first quarter of 2014. New York fell back into second place at 9.9 percent. The good news lost in all of this flip-flopping is that the vacancy rates for both markets have been declining, even as they jostle for the top spot.

Although Washington has faced some pressure due to the skirmishes over the federal budget, the most recent budget deal helps to assuage some of those fears. New York still has a lot of room for improvement. Most of the recovery in vacancy up to this point has been due to the increased presence of the technology industry in “Silicon Alley” in Midtown. Employment in the financial services sector has continued to stagnate, given the uncertain regulatory environment, but any turnaround in hiring in financial services usually translates into healthier demand for New York office space.

Looking ahead

Reis is fairly optimistic for the remainder of 2014. Job growth figures have beaten forecasts over the past couple of months, despite dire predictions of a severe slowdown in hiring because of an unusually cold winter. If the predicted monthly average of 200,000 to 250,000 jobs for the year does come to fruition, we fully expect to record the first meaningful acceleration in vacancy declines and rent growth this year.

Accordingly, Reis forecasts asking rents to rise by about 3.0 percent and effective rents to rise by 3.5 percent in 2014. Nothing that has occurred during the first quarter of the year—currency fluctuations and economic slowdowns in emerging markets, the annexation of Crimea by Russia—has caused us to alter our outlook significantly.

Brad Doremus is senior analyst, and Victor Calanog is head of research and economics for New York-based research firm
This article was republished with permission from National Real Estate Investor.

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