Medical office vacancy dips to a 10-year low

The Greater Phoenix medical office market closed 2017 in strong form, with the local vacancy rate reaching a 10-year low. Vacancy in local medical office buildings dipped below 15 percent in the fourth quarter, ending the year at 14.7 percent, identical to the rate at year-end 2007.

The vacancy rate was driven lower by healthy levels of tenant demand. Net absorption during the fourth quarter topped 245,000 square feet, the strongest single quarter since 2007.

While market fundamentals are improving, fewer medical office properties sold in 2017 than in the preceding year. This is likely a short-term dip in activity levels, and it is likely that sales velocity could gain momentum in the year ahead, particularly if the tenant demand recorded in the second half of 2017 is repeated in the coming quarters.

Key Takeaways:

  • The Greater Phoenix medical office market improved at the end of 2017, posting robust levels of net absorption during the fourth quarter. This drove the local vacancy rate to a 10-year low and resulted in modest rent growth.
  • Vacancy in medical office buildings fell by more than 100 basis points in the fourth quarter, ending the year at 14.7 percent. Vacancy in medical office buildings has been on the decline in each of the past eight years.
  • Rents inched higher to close the year, reaching $23 per square foot. Asking rents ticked up 1.3 percent in 2017, similar to annual gains that have been recorded each year since 2014.
  • The improvement in property fundamentals has been slow to translate to investment activity. Sales prices have been rising even as the number of properties changing hands cooled in 2017.
  • Cap rates for investment properties compressed to about 7 percent in the past year.

Outlook:

The strong net absorption displayed at the end of 2017 brightens the outlook for the Greater Phoenix medical office market in the year ahead. While the market has experienced strong tenant demand during the past two years, new development has been modest, and this trend is forecast to continue in 2018.

While there are a number of proposed medical office projects in the development pipeline, deliveries for 2018 will be minimal, which should allow for at least one more year of vacancy tightening in the local medical office market. With vacancies tightening, rents should edge higher for a fifth consecutive year.

To this point in the cycle, rent growth has been very slow to gain momentum. Historically, the strongest rent growth in the local medical office market has occurred when vacancy was in the 12 percent to 15 percent range and when development was active.

The combined impact of lower vacancies and the introduction of newer, more expensive buildings fueled annual rent growth in the 5 percent to 7 percent range during the last expansion cycle. In the year ahead, the vacancy rate will be in the range that has traditionally sparked rent growth, but new construction will be limited.

Current forecasts call for rent growth in the medical office sector of approximately 3 percent in 2018.