Unemployment throughout the United States is the lowest it has been since 2008. Propelled by robust job growth, the office sector is expected to continue to expand in 2018. Despite fears the U.S. construction boom would cause a potential slowdown, activity in the office sector remains largely expansionary, with the technology and creative sectors continuing to drive leasing activity. Although the office sector is expected to continue to grow this year, many owners and investors are reacting to the increased inventory in many primary markets across the United States. This supply increase, among other factors, has caused many investors to shift their focus to suburban markets in 2018.
Investors find these markets compelling for three reasons:
Increased migration of millennials: Historically, the millennial cohort has dominated urban cores throughout the United States. Today, this is shifting. As millennials reach marriage, home-buying and childbearing years, they increasingly are migrating out of urban cores to the surrounding submarkets. With nearly one-third of the workforce represented by millennials, this is creating more demand for office space in the outlying secondary markets that surround dense urban areas throughout the United States. While this shift in migration among millennials may have been delayed because many are waiting much longer to get married, have children and buy a house, it will only continue to grow over the next several years. The difference investors will have to note is, although millennials are migrating to outlying suburban markets, they are not going too far from the city, compared with generations past. They are moving right outside of urban core markets, to areas that are still highly amenitized and close enough to go into the city, if needed. These are the markets that will see an influx in office demand over the next five years.
Increased migration of technology tenants: The technology sector was one of the leading drivers of leasing activity in 2017, and this is anticipated to continue over the next several years. The Emerging Trends in Real Estate survey from PwC and the Urban Land Institute found the investment outlook was highest in secondary markets with an increasing technology base. These top secondary markets include Minneapolis; Portland, Ore.; Raleigh, N.C.; Salt Lake City; and Seattle. Tech companies are relocating to these emerging gateway markets for two different reasons. The first is chasing top talent. As millennials continue to migrate to these outlying regions, tech companies are following to tap into this highly educated workforce. Businesses also are relocating to these regions because they provide a strong value alternative to the extremely high rents in urban cores. Tech companies and other businesses are able to find the same high-quality office space in these emerging markets, creating a strong value proposition for tenants.
Increased yields: Investors also are shifting their focus to secondary markets because of peak pricing in urban markets. In many urban core markets across the country, prices have reached and even surpassed peak prices and replacement costs. This makes finding deals that pencil in urban cores much more difficult. With increased prices and cap rate compression, investors either must accept lower yields or invest in growth markets. Many are opting to invest in markets positioned for strong economic growth because of quality market fundamentals and demographics. Investors are able to acquire properties in these areas at rates much lower than replacement costs and still have room to grow rents. Compared with urban cores, where rents are starting to taper off and increased development presents a potential risk of oversupply, secondary markets present investors with a strong opportunity for value creation. Suburban markets also tend to have higher development restrictions because they often are dominated by single-family residences. Many big cities are offering developers incentives or tax breaks to spur development and economic revitalization. This is creating extremely high development pipelines in many urban core markets, resulting in potential over-saturation over the next few years and the risk of plateauing rents.
Ultimately, the office sector is poised to continue to perform over the next several years, despite fears of increased development and plateauing rents in many urban core markets. Investors who focus on emerging gateway markets surrounding urban cores will find strong opportunities to drive rents and returns for years to come.
Tim Lee is the vice president of corporate development and legal affairs at Olive Hill Group.