U.S. Office Market Posts Strong Third Quarter Absorption

Posted on October 21, 2011

With the construction pipeline all but shut down and reduced rents prompting many tenants to trade up for better or more efficient space, the U.S. office market absorbed a strong 19 million square feet in the third quarter, according to data presented this week at CoStar Group’s Third-Quarter 2011 Office Review & Outlook.

The leasing activity helped lower the national office vacancy rate slightly to about 13.1% — down nearly a half percentage point since hitting its peak a year ago. Should leasing activity remain at the level seen this past quarter, it would set the stage for future rent increases, since little to no new supply is being added. CoStar’s analysis found office rents firming or already trending up in some key metros, and more increases are expected to spread across the country by 2013.

Leasing activity, which bottomed out in early 2009, increased in the third quarter as tenants signed long-term commitments to lock in low rents for higher-quality Class A and B buildings. Gross leasing is now approaching levels not seen since the first Internet company boom a decade ago.

“If you know your corporation or group will have a long-term demand for space, there’s never been a better time to sign a 10-year deal,” stated Andrew Florance, Costar Group founder and CEO, who led the presentation Tuesday of the latest quarterly data. “You can feel pretty comfortable, as long as your broker negotiated a reasonable cap on escalation, that you’re going to love the rents you’re paying seven years from now.”

During the downturn, corporate downsizing emptied out office desks faster than companies could shed excess space. The market is still in the process of absorbing this “shadow” inventory, noted Jay Spivey, CoStar director of analytics.

With overall rents 11% below the long-term average, the market would normally expect elastic demand from tenants who take a larger amount of space per employee because it’s cheaper. However, tenants are being more conservative in assessing their space needs in the current economic environment.

Net absorption, which has been muted at under 10 million square feet for the last few quarters, jumped to 19 million square feet in the most recent three months and is finally beginning to reflect modest job growth generated during a volatile recovery.

The San Francisco Bay area, which has seen some of the most heavily discounted rental rates among office markets, led the country with 4.4 million square feet of net absorption in the third quarter. Similar net absorption strength was found in markets with heavy presence of technology and energy firms. The top five metros for absorption included Seattle/Puget Sound (2.5 million square feet absorbed) Boston (2.1 million square feet), Philadelphia (1.9 million), Houston (1.9 million) and Washington, D.C. (1.7 million). Northern New Jersey led a handful of markets that experienced negative absorption, also including Atlanta, Los Angeles, Westchester/So Connecticut, and Minneapolis.

One key indicator, the percentage of office submarkets with declining vacancy rates, rose again in the third quarter after dipping in the second quarter. CoStar economists track this number carefully because it has proven to be a solid leading indicator of both downturn and recovery. Current numbers suggest that tightening local markets should soon begin to see effective rent growth, noted Walter Page, director of research and office specialist for Property & Portfolio Research (PPR), CoStar’s forecasting and analytics subsidiary.

More than two-thirds of the 20 largest markets are seeing year-over-year occupancy improvements, according to CoStar data. Leading the charge is Orange County, CA, which is now recovering after being staggered by the mortgage and financial market meltdown.

Orange County’s recovery might be an indication that the distressed housing is no longer holding back office demand, and could provide hope for other housing-based markets such as Atlanta or Phoenix, Page said.

“Once we get housing going it will help lift the broader economy,” Page said.

The biggest caution sign facing the U.S. office market is the risk from federal cutbacks in certain metros, especially Washington, D.C. If Congress opts for the harshest federal cuts and job losses of the order of magnitude that the United Kingdom is experiencing, it would translate to an equivalent over the next five years of 8 million additional U.S. jobs lost.

Markets like Seattle, Dallas-Fort Worth and Houston are seats of the technology or energy industries with less exposure to federal spending, which could be a good bet for investors diversifying their portfolios, Page said.

Ultimately, recovering corporate profits should spark companies to reinvest and hire people to work in shopping centers and office buildings, he said.

“From a relative prospective, the business sector of the economy has strength,” Page said. “We don’t expect another recession, but rather a slow, volatile recovery that will take time.”

Randyll Drummer, Costar Group