Office Market Recovery Continues In Third Quarter Despite Election Year Jitters

Posted on November 2, 2012

Demand for office space in the U.S. held steady in the third quarter as leasing activity and absorption of available office space continued to pick up momentum following a lackluster start at the beginning of 2012, CoStar Group reported this week in the company’s Third-Quarter 2012 Office Review & Outlook.

The overall U.S. office vacancy rate edged down and net absorption rose to 15 million square feet during the quarter from 13 million square feet at mid-year 2012. The relatively little new office supply and continued low levels of new office construction supported the balance in supply and demand.

Meanwhile, office tenants continued to enjoy a ‘holiday’ from rent increases as office rents in most market have yet to budge much from their market trough tipping point, according to analysts for Property and Portfolio Research (PPR), CoStar’s analytics and forecasting division.

“The recovery is only one-third of the way there in the office sector, we still have two-thirds to go,” said Walter Page, PPR director of research, office, who was joined by PPR’s Managing Director Hans Nordby and Manager, U.S. Market Research Aaron Jodka, in dissecting the third-quarter numbers for CoStar clients.

If there was a surprise for the quarter it was on the upside. Page said he had expected demand to fall off a bit in the quarter, based on anecdotal reports of companies postponing hiring and expansion decisions due to economic and political uncertainties created by this fall’s hotly contested presidential election and the unresolved budget impasse.

“But it held up, and we expect it to continue to hold,” Page said, buoyed by the improvement in job growth over the last couple of months.

CoStar expects leasing activity to exceed 135 million square feet nationally for the third quarter, eclipsing the 130 million square feet of office space leased during the second quarter.

“We’ve started to see pretty good leasing momentum,” Jodka said. “It was a weak first quarter, but we’ve started to see more decision-making by tenants — not at the rate we would have expected if it were not an election year or if the economy were performing better — but we’re seeing office-using job growth translate into leasing decisions and momentum , and that’s a good sign.”

Energy industry driven metros such as Houston, Dallas and Denver, and even previously challenged growth markets such as Atlanta, have posted solid gains in leasing and absorption, both in the third quarter and year to date, fueled by growth in law firms, consulting, insurance and other typical downtown tenant, Jodka noted.

On the other end, consolidation among pharmaceutical companies and other office tenant downsizings have dampened demand in Northern New Jersey. Absorption remains soft in Los Angeles outside the submarkets dominated by media and entertainment companies.

Companies Continue to Pursue Modest Office Hiring

While U.S. GDP slowed to 1.3% in the third quarter from 1.7% in the prior quarter — hardly the kind of growth arithmetic that induces companies to hire more workers — office-occupying jobs continued to increase on a year-over-year basis at a faster clip than the national average, Nordby said.

“We’re expecting office-using employment to be about 30% better than the overall average in employment. If you believe there’s a recovery, then you like the office sector,” Nordby said.

Although the U.S. office vacancy rate edged down to 12.6% in the third quarter and is down just half a percentage point from a year ago, PPR continues to expect the vacancy rate to fall another 1.8% through 2016 as supply diminishes and the economy rebounds, by far the steepest drop among commercial property types.

For now, two main factors are constraining office demand. The average amount of office space leased by tenants has shrunk 21% over the last 10 years in a fundamental shift in the way companies use office space due to a variety of factors, including the economic downturn, and the rise of telecommuting and smaller, more collaborative work spaces. Secondly, tenants are still expanding into leased but under-utilized space resulting from layoffs during the recession.

Meanwhile, office tenants that have been active in the market are upgrading their space at the current lower rents. About 70% of net absorption has been in top-tier, 4-Star and 5-Star buildings. However, PPR expects absorption to shift to the middle and lower of the market, similar to the mid-2000s recovery, as the choicest buildings fill up.

Page also pointed out that office demand is improving in metros hurt by the housing crisis, such as Atlanta and Phoenix, with housing clearly less of a drag on their local economies than in previous years. Even in Orange County, where the subprime mortgage collapse caused the office market to crater, mortgage lenders are once again beginning to lease large block of space, Jodka said.

Office Construction Beginning to Stir

Although there’s very little new supply of office space coming on line — the nation actually removed more space from the inventory than it added in 2011 — construction of a few new projects totaling 14 million square feet has started in the last two quarters. Most of the new office construction consists of build-to-suit buildings for medical or pharmacautical tenants such as PNC’s 800,000-square-foot headquarters building in Pittsburgh.

However, office construction is becoming a bigger story in a few markets such as San Jose, CA; Boston, Washington, DC, Houston, New York City, Austin and Charlotte, NC. Although up to 85% of the space is preleased in some markets such as Boston, speculative projects have been a higher percentage of total construction in San Jose, DC, Austin and Charlotte.

“We expect that sluggish phenomenon to continue over the next several years until the economy really gets going and profits start to translate into employees and uncertainty starts to wind down,” Jodka said.

While the office sector had the greatest increases in vacancy and has not recovered as fast, its recovery probably has more legs going forward because of the lack of construction, Page said.

Randyl Drummer, Costar