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U.S. office market fundamentals remain strong

by Jody Barhanovich

U.S. office market fundamentals remain at their strongest point in the cycle, with peak occupancy and record rents, according to Colliers Q1 2017 U.S. Office Market Outlook Report. Yet, there is little doubt that the market has been cooling.

The national office vacancy rate has been virtually static for more than a year. Rents are still rising but the pace of appreciation is modest and slowing. Likewise, absorption is still positive, but first quarter 2017 was relatively quiet and activity was concentrated in suburban markets. Office space under construction rose for the third successive quarter in first quarter 2017, while investors continue to chase higher returns — leading to an increased focus on suburban and second-tier markets.

U.S. office net absorption fell for the second successive quarter in Q1 2017 to 3.2 million square feet, down from 12.9 million square feet in fourth quarter 2016. Suburban markets accounted for 90 percent of the first quarter 2017 absorption total. Tenant move-outs, renewals and downsizing continue to be the primary factors, but there is also a supply shortage in some markets. Stronger GDP growth is anticipated for the remainder of the year, which should underpin healthier demand.

The U.S. office vacancy rate fell marginally in first quarter 2017, dropping 10 basis points to 12.2 percent — providing further evidence that vacancy has plateaued. Since the beginning of 2016, vacancy has stayed within a 20-basis-point range and is now at the same point as at the peak of the prior cycle in third quarter 2007, when the rate bottomed at 12.2 percent.

Average class A asking rates in first quarter 2017 stood at $47.64 per square foot in downtown markets and $29.39 per-square-foot in the suburbs, representing a quarterly increase of well under $1 per square foot in both locations. On an annualized basis, class A downtown asking rates increased by 3.5 percent as of first quarter 2017 compared to 1.9 percent in suburban markets — down from the 12-month growth rates in fourth quarter 2016 of 4.1 percent and 2.7 percent, respectively.

Office construction remains elevated and deliveries are front-loaded. The volume of office space under construction has risen to 113 million square feet, up slightly from 110 million square feet at the end of 2016. Of this, 45 million square feet are under way in downtown markets and 68 million square feet are under construction in the suburbs.

Four markets continue to dominate the construction picture, accounting for almost half of current activity. The San Francisco Bay Area leads with 19.5 million square feet under way, followed by Dallas and Washington, D.C. (including Northern Virginia and Maryland), which both have more than 11 million square feet being built. New York rounds out the top four with 10.3 million square feet under construction.

Lastly, office sales volume fell by 12 percent over the previous quarter to $27.7 billion but remains healthy. Investor strategies continue to shift toward suburban and second-tier markets that provide higher yields, but there are still buyers for trophy central business district product. There is little upward pressure on capitalization rates, but rising interest rates are a concern.

 

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