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Restrained Pace of New Office Development in the US Expected to Lead to Continued Rent Growth

4/11/16

Tenant demand for office space slowed in the first quarter, dragged down primarily by continued weakness in the oil patch and a pullback in the tech sector, according to a new report from Cushman & Wakefield. Still, net absorption remained strong enough to push occupancy levels and rents higher in most markets across the country.

Following the strongest level of demand in nine years, total U.S. net absorption of office space slowed by 59% in the first quarter from the previous quarter to 9.7 msf. Despite the deceleration, tenant demand for office space kept pace with new construction. The national office vacancy rate remained flat at 13.5% in the first quarter – its tightest level since the third quarter of 2008. Of the 87 markets tracked by Cushman and Wakefield, 54 reported positive demand for office space in the first quarter, while 33 reported negative absorption.

Kevin Thorpe, Cushman & Wakefield’s Chief Economist, says the slowdown mirrors the choppy performance of the U.S. economy and was concentrated in certain markets.

“The financial market volatility to start 2016 weighed heavily on the tech sector in particular,” Thorpe said. “For the first time in years, we saw the venture capital faucet tighten, and certain tech hubs such as Silicon Valley and Boston began to pull back. The upshot is that conditions have stabilized after the first six weeks of the year, and U.S. businesses continued to add jobs at a healthy pace. The U.S. economy seems to be pulling out of this mini-Q1 slowdown, and given that job creation and consumer confidence have remained steadfast, we should see the office demand metrics pick up from here.”

U.S. office rents increased 4.1% in the first quarter compared to a year-ago, to $28.45. Office rents rose in 67 out of the 87 markets tracked by Cushman & Wakefield. The construction pipeline continued to expand modestly. In the first quarter of 2016, there were 9.5 msf of new office buildings that delivered to the market and 95.1 msf under construction expected to deliver over the next two years. Both readings were down slightly from the first quarter of a year-ago.

A number of factors indicate the U.S. office market will continue to tighten.

“Developers and lenders have held to a disciplined approach to new construction throughout this cycle,” said Kenneth McCarthy, Cushman & Wakefield Principal Economist and Applied Research Lead. “The combination of equity market declines early in the quarter and continuing weakness in energy-driven markets has reinforced this discipline. In the first quarter, approximately 2.0% of existing inventory was under construction or completed, roughly the same share that has held for more than a year now. By contrast, in 2007/2008 new construction represented 2.5% of existing inventory, and in 2000/01 it reached 4.3%.”

The highest office rents in the U.S. continue to be observed in Midtown Manhattan at $78.40 per square foot, but San Francisco, which has the lowest vacancy rate in the country at 5.7%, has closed the gap with asking rent averaging $68.44. As recently as the beginning of 2010, the difference between Midtown Manhattan and San Francisco was $30.30, while today it is just shy of $10.00.

“The reality is, the office sector is underbuilding relative to office-using job creation,” said Thorpe. “So even when the economy throws a weak absorption number on the board, vacancy stays tight. The way this is tracking, if job growth continues to follow a similar script, then we are going to see rent growth spike to double-digits in a growing number of markets this year.”

In the first quarter of 2016, the top 10 strongest markets in terms of demand for office space were Dallas/Fort Worth, with 2.2 msf of absorption; Denver, with 909k sf; Miami, with 907k sf; Philadelphia, with 818k sf; Phoenix, with 725k sf; Charlotte, with 670k sf; San Diego, with 623k sf; Seattle, with 612k sf; Austin, with 581k sf; and Palm Beach with 518k sf.

The top 10 markets in terms of rent growth were San Jose, with 22.1% year-over-year rental appreciation; Dallas/Fort Worth, with 17.5%; San Mateo County, with 16.5%; San Diego, with 13.5%; San Francisco, with 12.4%; Miami, with 11.8%; Palm Beach, with 11.7%; Seattle, with 11.6%; Puget Sound-Eastside (formerly Bellevue), with 10.4%; and New York (Midtown South), with 8.4%.





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