Office Markets Show First Signs of Beginning a Long Slow Road to Recovery
Without raising expectations to unrealistic levels, this quarter’s results suggest the office market has indeed hit bottom and has begun what will almost certainly be a very long and slow road to recovery. Although the economy continues to languish and job growth remains disappointing, third quarter occupancies improved for the second three month period and the national vacancy rate posted a slight decline. Canadian markets also registered modest growth, helping to round a good quarter for North American office markets. With both the U.S. and Canadian economies posting reasonable growth and the addition of more private sector jobs, leasing markets are expected to continue improving, albeit only in small increments with no sudden surge anticipated.
Third quarter data reaffirms our view that the U.S. office market has entered the first phase of what will likely be a multi-stage recovery. Most encouraging is the nine-month-long gain in private sector employment. Furthermore, office-using employment was reasonably strong during the July-September period, suggesting office leasing activity is unlikely to fade. The uncertainty surrounding the midterm elections and the possible extension of the Bush administration tax cuts may dampen office leasing demand for the fourth quarter, but that should only be a temporary phenomenon. Widespread increases in rents are unlikely anytime soon, but occupiers in select markets would be wise to lock in today’s lease rates before lower availabilities give landlords the upper hand.
U.S. office vacancy rate down marginally.
The U.S. national office vacancy rate moved slightly lower during the third quarter, moving two basis points lower (100 basis points equals one percent). This represented the first drop (albeit very small) in vacancy after eleven consecutive quarterly increases. Office vacancies finished the quarter at 16.28 percent and possibly marked the beginning of a long gradual decline in vacancy. During the third quarter the Downtown vacancy rate decreased 8 basis points to register 14.86 percent while suburban vacancies held steady at 16.91 percent. One change of note was during the quarter downtown Class A vacancies moved significantly lower, dropping 32 basis points to register 15.87 percent. Canadian office vacancy rates were mixed with central business district (CBD) vacancies rising 4 basis points to 7.16 percent while suburban vacancies decreased 8 basis points to 9.02 percent.
Office occupancies up for the second consecutive quarter.
Possibly heralding the beginning of the next up cycle, U.S. office markets collectively posted another quarter of positive absorption. This second quarter of positive absorption came after nine consecutive quarters of negative absorption beginning first quarter 2008. Third quarter absorption came in at 6.6 MSF (million square feet) which was a substantial increase from the second quarter when occupied space increased by 1.8 MSF. Third quarter absorption was also a significant improvement from the year ago period when 17.7 MSF was returned to the market. Examining third quarter absorption in detail shows 92% of newly occupied space was in Class A buildings reflecting a move by tenants to upgrade their premises often with little additional cost. Canadian markets also recorded an increase in occupied space during the third quarter with absorption totaling 2.7 MSF.
Rent picture increasingly mixed.
Third quarter rent data shows CBD rents increased a further 1.4 percent to average $39.06 per square foot while suburban rents largely held steady dropping by just two cents a square foot to $26.22. Looking beyond the headline numbers, however, shows most office markets are still characterized by declining rents. The reason for this apparent contradiction is rental averages are inventory-weighted and so a few large markets can skew the national averages. Without this “weighting” effect, third quarter CBD rents fell 0.4 percent and suburban rents dropped by 1.6%. Canadian downtown office rents moved lower during the quarter with CBD quoted rents decreasing 2.7% while suburban rents increased 1.2%.
Office construction pipeline continues to empty out.
Third quarter office completions totaled just 5.4 MSF, a significant drop from the second quarter when construction totaled 11.1 MSF, and the lowest on record. Going forward office development will remain extremely subdued with construction activity falling to just 20.6 MSF at quarter end, compared with 29.2 MSF at the end of the second quarter and well below the 120 MSF underway at midyear 2008. Construction is expected to drift lower and with the exception of just a small number of build-to-suits and a few select speculative developments, office development will be absent from the U.S. office landscape by as soon as mid-2011.