As published in Scotsman Guide's Commercial Edition, March 2012.
In this past December’s Property TypeCast, we discussed how the economic landscape in third-quarter 2011 cast some doubt on whether the office sector would continue recovering. Fourth-quarter results provided some reassurance that the nascent recovery was not derailed by fears surrounding a second recession in the U.S.
National vacancies continued falling at a modest pace this past fourth quarter, reflecting the slow improvement in conditions for office properties across the country. The vacancy rate declined by only 30 basis points from its starting level of 17.6 percent, ending this past year at 17.3 percent.
The sector absorbed 5.3 million square feet, the fifth-consecutive quarterly gain in occupied stock since late 2010. After five quarters of squeezing out gains in occupancy, the office sector has assuredly turned the corner and begun the process of recovery. Net absorption adds up to 20.7 million square feet for the year — a clear reversal from 2010’s loss of 16.7 million square feet of occupied space.
Given the lackluster pace of economic growth, it will be years before the office sector climbs out of the hole, however. Although 20.7 million square feet of positive absorption in 2011 is laudable, the sector has shown the capacity to absorb this much space in a single quarter in healthier times. National asking- and effective-rent growth eked out gains this past fourth quarter, showing a consistent trend upward. Annual gains of 1.6 percent and 1.9 percent, respectively, represent a turnaround given the ground lost in 2009 and 2010.
The fate of office properties is linked to the labor markets more than any other commercial property sector. Job creation has been positive but modest in the past two years, and the heightened level of market uncertainty isn’t prompting employers to consider hiring or leasing additional space. There is certainly positive churn in leasing, but rents remain at levels last seen in 2007, and five-year leases coming due this year have a high likelihood of being signed at equivalent or lower rent levels.
Previous downturns for the office sector were complicated by overbuilding; this time around, the massive decline in aggregate demand isn’t weighed down by a supply glut. National completions from 2004 to 2008 averaged only 49.3 million square feet per year; by contrast, office development in the five-year period preceding this (1999 to 2003) averaged 101.5 million square feet per year. In other words, although the sector lost significant occupied space, it could have been worse if the pullback in demand was combined with oversupply. Building in 2011 was restrained. Only 2.433 million square feet came online this past fourth quarter; the year-end total of 12.324 million square feet represents the lowest level of new additions to inventory in 15 years.
It is still the early stages of recovery for the office sector, and fundamentals are improving at roughly the same measured pace as national figures on economic growth and job creation. Barring any shocks that might force a double-dip recession, expect rents and occupancies to follow the same modest trajectory this year.
Victor Calanog, vice president of research and economics at Reis Inc., writes a monthly column on property types for Scotsman Guide. He and his team of economists are responsible for data models, forecasting, valuation and portfolio services for clients in commercial real estate. Reach him at email@example.com.
Brad Doremus, senior analyst for Reis’s economics department, contributed to this article.