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Demand for small commercial buildings declines

Demand for space in smaller commercial properties fell significantly for the second-straight quarter, the one troubling warning signal in an otherwise booming market for small-cap office, industrial and retail properties, according to the tracking company Boxwood Means.

Companies absorbed a net 17.9 million square feet in the commercial properties in the second quarter, which was the lowest gain in absorption involving buildings under 50,000 square feet in 24 consecutive quarters, Boxwood Means said. Net absorption through the first six months, at 37.4 million square feet, was the weakest first-half total since 2011, when the small-cap market really began to recover from the Great Recession.

smallcapcommThe small-cap market is running at a peak level in other ways, however. Vacancy rates for the commercial properties were at record lows, in the aggregate, about 2 percentage points lower than the pre-recession low. Lease rates for office, industrial and retail have also hit new record highs on a nominal basis.

Boxwood Means principal Randy Fuchs said the lower absorption levels are troubling, though, given that the economy grew by a healthy 4.1 percent in the second quarter. He said there are two possible reasons why companies have pulled back.

First, many companies have struggled to fill open positions, thus discouraging expansions. The bigger issue, however, may be a growing “disequilibrium” between supply and demand for space. In this case, the problem is not that there is too much available space in the market, and too little potential demand, according to Fuchs. It is that construction has been subdued, and the new deliveries of small commercial spaces have not kept pace with demand across all sectors of the small-cap market.

The number of completed projects delivered in the second quarter ran about 40 percent lower than the long-run average dating to 2006, and the projects in the pipeline were about a third less than the norm. A lack of choices in an ultra-tight market where rents are at a peak cost, Fuchs said, is likely discouraging companies from relocating or expanding into new space.  

So far, Fuchs said, this supply-demand imbalance has been to the advantage of the building owners by pushing up the property values and keeping vacancy rates at unusual lows.

Investor interest remains high. The deal volume involving commercial assets valued under $5 million was on a record pace at $38.7 billion through April, Boxwood Means said. Fuchs said it’s still a bit too early to tell if the lower absorption will begin to weaken rental growth, or dampen investor enthusiasm in small-cap properties.

“We're in a bit of unprecedented territory with the record-low vacancies coupled with so little new supply,” Fuchs told Scotsman Guide News. “Add the soaring rents into the mix, and you have all the ingredients for more severe contraction in demand,” he said. “Let's see what happens over the next quarter or two. By then we'll likely see if  the small-cap CRE market expansion is in real trouble or not.”


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