The rebound in the office leasing market continued to spread across the U.S. in the first quarter.
The vacancy rate has fallen by 40 basis points in each of the past three quarters. And during the past four quarters, vacancy has fallen in 40 of 49 markets tracked by Grubb & Ellis Co. The average class A asking rental rate increased in 33 markets in the past year.
Net absorption was three times higher than space completed during the period while the construction pipeline remains stable. Expect the recovery to continue at a moderate pace during the next few quarters.
Current Conditions
The office market notched another strong performance in the first quarter. Vacancy fell, absorption outpaced completions by a wide margin, the construction pipeline remained subdued and average rental rates rose modestly for class A and B space in central business districts and suburbs.
Vacancy fell by 40 basis points to end the first quarter at 16.4%, matching its pace of decline from the fourth quarter. If vacancy continues to fall at this pace, it will reach 15.2% by the end of 2005 and 13.6% by the end of 2006,a reasonable expectation if the economy avoids any big pitfalls.
The average suburban vacancy rate of 17.1% remains higher than the 15% average vacancy in central business districts. But the recovery is brisker in the suburbs where vacancy has fallen 230 basis points from its peak, compared to just 40 basis points in central business districts.
One reason for this is that downtown rental rates are higher than suburban rates in most markets, attracting cost-conscious tenants to the suburbs. Another possibility is that large, publicly traded corporations and financial institutions filling downtown high-rises are more prone to mergers, layoffs and outsourcing compared to the smaller, privately held companies that populate suburban office markets.
Bakersfield and Dallas-Fort Worth posted the lowest and highest big-market vacancy rates in the first quarter at 5.4% and 24.2%, respectively.
Silicon Valley Vacancy Plummets
During the past four quarters, vacancy plummeted by 530 basis points in San Jose, more than any other market area.
That’s an amazing result because San Jose is only one of two metropolitan areas where payroll employment shrank during the past 12 months. The other one is Detroit.
One explanation could be that the ranks of the self-employed (not counted in the payroll employment survey) have been expanding as Silicon Valley technology companies hire independent consultants instead of full-time employees to maintain a flexible workforce and hold down healthcare costs.
Similar market dynamics are occurring in nearby San Francisco and San Mateo, where payroll employment is growing slowly but vacancy rates are falling.
Even more surprising is that rents in these two markets have been increasing in recent quarters while vacancy rates remain elevated.
National Absorption
Tenants absorbed a net 15.9 million square feet in the first quarter, nearly four times the 4 million square feet delivered to the market. Absorption remarkably has been consistent during the past four quarters, in the range of 15 million to 17 million square feet per quarter.
Northern and Central New Jersey and metropolitan Washington, D.C., finished the first quarter in a virtual tie, both absorbing 2.1 million square feet.
Third-place Los Angeles and fourth-place San Jose also finished in a dead heat with nearly 1.1 million square feet absorbed in each market.
Many markets continue to see demand slip, led by Cincinnati, Columbus, Ohio, and Detroit, but even fast-growing Phoenix got off to a slow start with negative absorption in the first quarter.
The amount of space in the construction pipeline totaled 40 million square feet at the end of the first quarter, roughly where it has been for the past two years.
Of the total construction, 33.7 million square feet is speculative, and 6.3 million square feet is build-to-suit. Five spec buildings larger than 500,000 square feet are under construction in downtown markets, including three in Chicago and one each in Manhattan and Philadelphia.
Four non-central business district projects also fit this profile: two in southwest Washington, D.C., and one each in Los Angeles (Century City) and Atlanta (midtown).
OC Leads Rent Spike
Class A and B asking rents increased 1.8% and 2.2%, respectively, during the prior four quarters.
Class A asking rents posted annual gains in 33 of the 49 markets that Grubb & Ellis tracks. Orange County led the spike with an 11% jump.
The average class A asking rate fell by 4.8% in Grand Rapids, Mich., and by 4.1% in San Jose, though the latter market is beginning to see rent increases in selected submarkets and properties.
Sublease space offered on the market continues to fall at a steady pace, ending the first quarter at 96 million square feet. This is down from the peak of 146.5 million square feet three years ago but still about three times the late-1990s average when dot-com mania drove frenzied demand.
New York City claims 12.4 million square feet of available sublease space, the highest total among all markets. But nearby Fairfield County has the highest ratio of sublease space to total office inventory at 6% compared to the national average of 2.7%. San Mateo and Boston follow closely.
The office market is responding well to the growing labor market, which has created nearly 3.5 million net new jobs since its low point 23 months ago.
That is an average of 151,000 net new jobs per month, below the benchmark level of 200,000 considered to be a healthy rate of expansion, but it has been enough to push vacancy lower and absorption higher.
Look for more of the same during the next few quarters,slowly tightening vacancies that will translate into slowly rising rental rates.
The pace of the recovery will be uneven, varying by region of the country (slower in the Midwest), market, submarket and building class.
High-quality spaces in the most desirable submarkets will disappear first. And, as rents rise for the better spaces, tenants are expected to begin to trade quality for better rent.
Investment Update
Office market investment transactions above $5 million totaled $15.8 billion in the first quarter, 26% above the total for the first quarter last year.
Real estate investment trusts and foreign investors were net buyers, private national companies were a wash, and all other investor categories were net sellers.
Capitalization rates remained at or near historic lows, driven by low, stable interest rates, abundant capital and the improving leasing market.
Cap rates ended the first quarter at 7.8% for suburban properties and 7.2% for downtown properties.
The unleveraged total return (income plus appreciation) for institutional office properties tracked by the National Council of Real Estate Investment Fiduciaries, registered a solid 3.25% in the first quarter.
Analysis by Grubb & Ellis Co.
