A slow start for the office market

Victor Calanog, vice president of research and economics, Reis Inc.

As published in Scotsman Guide's Commercial Edition, June 2012.

With few major drivers of office demand improving at a significant pace, fundamentals predictably stuck to the measured pace of recovery seen over the past year. The national office vacancy rate fell by 10 basis points to 17.2 percent at the end of this past first quarter. The sector absorbed about 6 million square feet, the fifth consecutive quarterly gain in occupied stock since the beginning of 2011.

Although levels remain muted, five consecutive quarters of positive net absorption provide consistent evidence that the sector is recovering. These levels are a far cry from what the sector is capable of attaining in healthier periods; the past five quarters reflect weak economic growth and an anemic labor market recovery. Given the rate of improvement, it will be years before the sector is able to recover the space that was vacated in the recession and early stages of the economic recovery. The national vacancy rate has regressed back to levels unseen since 1993 and remains well above the cyclical low of 12.5 percent from 2007.

National asking and effective rent growth improved slightly this past first quarter, continuing the slow upward trend that began in first-quarter ’11.  Annual gains of 1.6 percent and 2.1 percent, respectively, also indicate a moderate pace of improvement but are unimpressive.

The office sector continues to be hampered by the anemic pace of improvement in employment. The labor market is struggling to consistently gain more than 200,000 jobs per month. By historical standards, this is weak for periods of economic recovery. Despite strong profit margins and balance sheets, companies have been reluctant to expand payrolls, especially among smaller firms. Although there are some indications that this is improving, we remain cautious because the sector was in an uncannily similar position in first-quarter ’11. There is certainly positive churn in leasing, but rents remain at levels last seen in 2007, and five-year leases coming due this year run the risk of being signed at equivalent or lower rent levels.

On the plus side, weak supply growth remains a tailwind for improvement. This past first quarter, less than 2 million square feet of office space were completed. This represents the lowest quarterly level on record since Reis began tracking it in 1999. Although supply growth was restrained in the years leading up to the recession, it has fallen even further since the recession hit. With little supply being delivered, even low levels of absorption are sufficient to generate vacancy-rate declines and rent growth. This is different from past cycles, where supply growth prior to recessions was a complicating factor. If we had similar supply increases in the last growth phase of the economy before 2008, the current relatively weak demand for space would be insufficient, and improvement in vacancies and rents would be even more subdued.

In this past March’s Property TypeCast, we speculated that the office sector’s recovery would follow the same modest trajectory unless economic growth and job creation ramped up significantly. There were few surprises this past first quarter, either on the upside or downside. In a world of tempered expectations and heightened downside risks, perhaps that is the best for which we should hope.

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 victor.calanog@reis.com.

Brad Doremus, senior analyst for Reis’s economics department, contributed to this article.