Construction activity in the U.S. office market remains elevated while absorption levels are muted. Is this pattern set to continue leading to rising vacancy and downward pressure on rents and pricing?
The amount of office space under construction in the U.S. stands at 117.2 million square feet. Development activity declined in the second half of 2017 but has risen by 10% year to date to Q2 2018. Placing current activity in context, the long-term under construction average is 78.5 million square feet, and the all-time high is 125.2 million square feet which occurred during Q2 2008. Deliveries during the first half of 2018, at 34.8 million square feet, are on par with the 2017 total of 68 million square feet.
On the demand side annual net absorption has been on the decline. Net absorption fell to 58.3 million square feet in 2016, with a sharper drop to 39.2 million square feet in 2017. Based on activity in the first half on this year, net absorption is on pace to fall further, to a total of only 35 million square feet in 2018.
The long-term annual absorption average is 50.4 million square feet, but this includes seven consecutive quarters of negative absorption during the Great Recession in 2008 and 2009 which saw national office vacancy rise from 12.8% to 16%. Over 130 million square feet of new office space was delivered during the same time-period. Excluding this extended period of negative absorption raises the annual average to 65.4 million square feet.
Supply Meet Demand
So far in the current cycle, there has not been a significant enough supply/demand imbalance to impact vacancy and rents at the national level. Office vacancy stands at 12% and has been effectively stable for 10 successive quarters. Demand is being shored up by tech and coworking firms. Traditional business sectors, particularly law firms, are mostly in consolidation mode and seeking more efficient space configurations. When leases are signed or renewed there is typically a 10% to 20% reduction in footprint. Accordingly, while the economy is still adding office jobs, this is not translating in to an increase in office occupancy.
The overall economy remains strong with 4.1% GDP growth in Q2 2018 and 3% growth anticipated for this year overall. The consensus view is that growth could start to slow during the second half of 2019, but barring a major geopolitical or policy shock, a significant correction appears unlikely. Trade tariffs are causing economists to take a more sanguine view and could have a more significant impact if tensions continue to escalate.
Placing the current economic outlook in context compared to the financial and subprime mortgage crises of 2007 to 2009, the U.S. unemployment rate doubled in two years to 9.3% at year-end 2009 and household net worth fell by 17.3% and didn’t fully recover until Q3 2012. The bottom fell out of office demand with Manhattan alone posting over 10 million square feet of negative net absorption in 2009.
Localized Supply Threats
What’s happening below the national picture? Five metros collectively account for almost half (46%) of the space underway; New York at 15.6 million square feet, the San Francisco Bay Area at 14.3 million square feet, Washington, D.C. at 8.7 million square feet, Dallas-Fort Worth at 8.3 million square feet and Seattle-Puget Sound at 6.9 million square feet. The New York total is almost exclusively in Manhattan and centered on Hudson Yards, which is seeing healthy pre-leasing and achieving some of the highest rents in the market. The amount of space underway in Dallas-Fort Worth has fallen by three million square feet over the past year as a wave of large corporate campus developments comes online.
Measured as a percentage of inventory, Austin leads construction activity at 5.9% followed by Charleston at 5.7%. Tech-centric markets remain the principal focus of development activity with construction elevated in Seattle-Puget Sound at 4.9% of inventory, Charlotte at 4.7% and the San Francisco Bay Area at 4.5%. Denver and Raleigh-Durham follow next with both at 3.8%.
Localized supply-side issues are emerging. Los Angeles and Washington, D.C. merit the greatest concern with 1.5 million square feet delivered in The District alone in Q2 2018. Downtown LA is set to add almost one million square feet in early 2019, all of which is available. While not excessive, new supply is on the way in core parts of Dallas and Seattle that will test the strength of tenant demand.
No Major Cause for Alarm . . . Yet
In summary, a national supply-side crisis appears unlikely over the short to medium term, so long as demand remains positive, the outcome of which is mostly in the hands of tech and coworking firms.
However, landlords are facing multiple challenges. Outside of low vacancy/high demand markets, most notably the San Francisco Bay Area, there is pressure on effective rents being compounded by continually rising labor and material costs. Additionally, what is the best way to respond to the phenomenal growth and success of coworking firms, especially WeWork? Coworking firms are not only drawing tenants but also developing operations that compete with business lines such as property management, leasing and space design.
As firms continue to seek the best quality environment to attract and retain talent, the problem is generally not leasing new high-end space but how to re-purpose and reposition the outdated, commodity space that is being left behind. Adaptive reuse is one option, but we are potentially facing a situation where office vacancy may rise, not due to elevated construction, but a structural increase in challenged space.
Stephen is the National Director of Office Research for Colliers International, where he focuses on analyzing office property trends, compiling Colliers’ thought leadership and delivering timely market projections to provide clients with a leading edge in our industry.