U.S. Office Market Begins the Year on a Soft Note

by CoyDavidson on May 17, 2011

North American Office Highlights | 1Q 2011

The U.S. office market began the year on a more muted note with only a modest increase in occupied space and little change in vacancy. Rents continued to languish, but for the first time in three years both downtown and suburban rents managed to eke out small gains. With the economy not yet firing on all cylinders and total employment showing only lackluster growth, the outlook for the office space market is far from certain. Higher energy costs are starting to impact business decisions and, as a result, demand for office space. By comparison, Canadian markets enjoyed a reasonably good quarter on the back of robust economic growth and a healthy labor market. Both U.S. and Canadian economies are expected to make gains in 2011, but the sudden surge in energy prices is a fairly stiff headwind that is likely to put a damper on corporate expansion and add to inflation concerns.

First-quarter data confirms our view that the U.S. office market recovery will be uneven in nature and fairly volatile. Manhattan, Washington, San Francisco and Boston remain the clear leaders in terms of fundamentals; yet Dallas, Denver, Houston, Northern New Jersey, Philadelphia, Raleigh, San Diego, San Jose, Seattle and West Los Angeles all showing encouraging signs. Also somewhat positive is the thirteen-month-long gain in private-sector employment. Furthermore, office-using employment was reasonably strong during the January-March period, with professional and businesses employment in particular up 3.2% year-over-year (March). Widespread increases in rents are unlikely to occur in 2011 and any boost is likely to be foreshadowed by a reduction in inducements which have not yet materialized beyond a handful of markets.

U.S. office vacancy rate holds steady. The U.S. national office vacancy rate barely budged during the first quarter, shifting just one basis point higher (100 basis points equals one percent). Office vacancies finished the quarter at 15.46 percent but are still on track to finish the year below 15.00 percent. During the first quarter, downtown vacancies increased 7 basis points to register 14.19 percent. Suburban vacancy rates nudged lower, falling 3 basis points to 16.07 percent. Over the past 12 months, the U.S. national office vacancy rate has fallen 21 basis points. The flight to quality was particularly evident this quarter reflected by Class A vacancies, which shrunk 21 basis points. Canadian office vacancy rates were mixed for the quarter, with central business district (CBD) vacancies falling 26 basis points to 6.75 percent, and suburban vacancies increasing 16 basis points to 8.76 percent.

Office absorption positive for fourth consecutive quarter. The U.S. office market registered a fourth straight quarter of rising occupancies. First-quarter absorption came in at 8.1 million square feet (MSF)—substantially below the fourth quarter of 2010, when occupied space increased by 14.8 MSF, but a considerable improvement from a year ago, when occupied space contracted by 5.1 MSF. Repeating a trend witnessed last quarter, Class A buildings continued to attract “move-up” tenants with Class A absorption totaling 10.4 MSF, compared to Class B and C buildings which saw a mild contraction in occupied space. Canadian markets also recorded an increase in occupied space during the first quarter, with absorption totaling 2.6 MSF. This was just marginally below the 2.3 MSF recorded in the fourth quarter.

Rents continue to form a bottom. First-quarter data shows CBD rents increased by 0.7 percent to average $39.55 per square foot. This came on top of 0.9 percent increase in the fourth quarter. Suburban rents increased by 0.6 percent to register $26.20 per square foot. Although small, this was the first increase in suburban rents since Q1 2008. Taking out the effects of some of the larger, higher-priced markets, both downtown and suburban rents held steady during the quarter. Canadian downtown office rents moved higher during Q1 with CBD quoted rents increasing 4.2 percent while suburban rents increased 3.1 percent.

Office construction takes a surprising jump. First-quarter office completions totaled 7.5 MSF, nearly doubling the fourth quarter, when construction totaled 3.8 MSF. By historic standards, however, first-quarter completions were extremely low—a trend that is expected to continue. It should also be noted that four markets account for more than 50 percent of Q1 new supply: downtown Cincinnati, downtown Houston, downtown Seattle, and Menlo Park on the San Francisco Peninsula. Going forward, office development will remain extremely subdued, reflected in construction activity which registered just 25.7 MSF at the end of the quarter. Last quarter, construction underway registered 22.3 MSF. The Canadian office market had very little new construction during the first quarter, adding just 336,000 square feet; however, across the country 6.6 MSF was under construction at the end of the quarter.

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