Economy, Leasing Bode Well for Office Markets

The US economy has slowed from the strong growth of 2004-2006. Real GDP increased at a 2.1% annual rate in the second half of 2006, compared with 4.1% in the first half. This slower growth trend is expected to continue during the first half of 2007 as the full effects of the Federal Reserve’s interest rate increases are felt. However, although they have increased from their lows of a few years ago, interest rates remain low enough to continue to support economic expansion in a low inflation environment. This, plus continuing employment income growth, will support consumer spending which is expected to increase in the second half of the year. In addition, stronger growth in business investment will accelerate economic growth. By the second half of 2007, economic growth is expected to rise back toward its trend growth in the 3% to 3.5% range.

OFFICE MARKET REVIEW

The US office real estate market ended 2006 on a very strong note. Overall office vacancy rates dipped to five-year lows, averaging 10.6% for all CBD and 14.5% for suburban markets that Cushman & Wakefield tracks. The catalyst for this performance was a marked improvement in tenant demand which accelerated as the year progressed. Healthy growth in office-using employment boosted demand for space, with close to 80 million sf absorbed throughout the country–the highest level since 2001. Moreover, even while new completions in 2006 were nearly double the 2005 level, absorption was robust enough that only 14 million sf was available out of the 45.9 million sf that came online. That has put strong upward pressure on rental rates. The average asking rental rates for both direct and sublease space jumped over 20% from 2005 to $22.98 per sf among CBD markets and 10% to $20.43 per sf in suburban areas. The escalation reflects the rent spikes in top-grade space, and was most apparent in the New York City market. Notably, more than 40 leases were signed with rents fetching over $100 per sf, surpassing the number of leases with rental rates of $100 per sf signed for all previous years combined.

The combination of a solid US economy, healthy leasing fundamentals and significant liquidity, also fueled investment activity throughout the country. Both the largest investment sale in history and the highest price per square foot took place during 2006. The volume of investment in office buildings reached a record $146.7 billion, up 47.6% from 2005. Indeed, all of this signifies an underlying faith in future economic growth as well as a continued vote of confidence in the office market.

CBD Outlook

The solid market fundamentals that characterized office real estate in 2006 are expected to continue into 2007 with steady growth in office-using employment. C&W believes that the US economy should have enough staying power to keep the job market taut enough to spur demand for office space in the CBD. Absorption is likely to remain highest in major markets including New York City, Washington, DC, Boston, San Francisco, and Seattle, which will account for nearly 60% of gains through 2008. Sustained, albeit slower, growth in government spending in traditional centers such as Washington, DC and Seattle, a continued vitality in the financial and services sector in the Northeast Corridor, and a revival of the technology sector in California underpin our expectations for continued demand momentum in these markets. Moreover, one positive aspect of the outlook is that the improvement in demand will be widely distributed across office-using sectors and should permeate all regions of the US.

Such favorable prospects continue to fuel speculative construction. By year-end 2006, speculative projects accounted for nearly two-thirds of the construction pipeline, the highest share since 2001. However, there should be no cause for concern: completions will remain modest at nearly 18 million sf over the next two years, and largely preleased upon delivery. All told, expect a gradual decline in office vacancy rates throughout the country, with the national average likely to hit market equilibrium (10%) by 2008. We expect 35 out of the 42 CBD markets to post flat to declining vacancies through 2008, with large markets (with the exception of Chicago) continuing to lead and post single-digit vacancies. The surge in new construction in Bellevue, Palm Beach, and Orlando, FL will weigh on these markets but not enough to erode rent gains. Overall, we expect rental rates to remain on an upward trend, growing an average of at least $1 per sf every year. There is a strong possibility that class A rental rates will continue to break records and even exceed the 2001 peak of $30.16 per sf.

Non-CBD/Suburban Outlook

Suburban markets are also set to continue their path to recovery. Even as new construction continues to boom and inundate suburban markets, healthy job creation will continue to bolster tenant demand. As a result, C&W expects 42 out of the 52 suburban markets to register flat to declining vacancies through 2008. Markets on the West Coast are expected to lead growth, generating nearly 40% of absorption gains over the next two years. Not surprisingly, overall vacancies will likely remain lowest for this region, with Bellevue and the entire Los Angeles County being the tightest. Such strong showing is tied to a robust regional economy that will buttress above-average employment gains through 2008. Overall, the average vacancy rate among suburban markets is expected to slide another 1-2 percentage points over the next two years. This, in turn, should help shore up rents by $1 to $2 per sf through 2008.

Of course, there are risks in the outlook. Current concerns about the subprime mortgage market have raised fears that the US economy may be at risk. This could make businesses a little more cautious, and possibly curb employment gains as well as have serious consequences for the office market. However, C&W believes that the economy has plenty of momentum that should allow it to withstand the problems in the subprime market. Moreover, current healthy conditions in most major office markets will help temper the effects of a potential economic fallout.

Maria Sicola is the senior managing director, research at Cushman & Wakefield. The views expressed in this article are the author’s own.