Despite Slowing Growth, Further Upside Remains for U.S. Office Market
As we reflect on Q4 2016 activity and our outlook for 2017, the U.S. office market seems to be reaching equilibrium. While rents increased modestly in 2016, rent growth has slowed considerably and vacancies appear to be bottoming out.
In 2017, we expect that economic growth will provide a boost to the U.S. office market, but overall, the market will move forward at a slower pace.
- Absorption Drops but GDP Growth May Bolster Demand: Net absorption fell in 2016 as occupiers sought to limit costs. New leasing has been restricted by an increase in downsizing, consolidation and renewals as well as backfilling shadow space. Still, increased GDP growth in 2017 could help offset this trend and early 2017 leasing volume in Manhattan bodes well. Financial services and technology companies should continue to lead leasing activity. If enacted by the new administration, deregulation and business tax reductions may lead to demand gains, though it will take some time to filter through the market.
- Vacancy Troughs as Rent Growth Slows: At the peak of the prior cycle in 2007, the national office vacancy rate fell to a low of 12.2%. In 2016, the vacancy rate held at virtually the same level. While Class A rents in most markets are holding firm or growing at a reduced pace, tenant incentive packages are increasing in some locations where vacant new supply is being added or occupiers are moving out.
- Most Markets Are Still Improving: Almost 75% of the metro office markets tracked saw an increase in asking rents and a fall in vacancy rates in 2016. Just over 60% experienced positive net absorption. This national picture shows even stronger office market performance than identified in our Q4 2016 Top Office Metros Snapshot.
- Market Cores Continue to Shift: Suburban markets account for most current absorption, driven by large build-to-suit campuses and new urban environments that compete with traditional downtown locations. Office tenants are not abandoning downtowns but the desire to be located near highly-qualified, young professionals who prefer urban living must be balanced against the limited availability of large blocks of space.
- Pre-Leased Space Leads Development Activity: Construction activity remains elevated but the majority of space under construction is pre-committed. The delivery pipeline is also heavily front-loaded, so deliveries will likely ease by 2018. Speculative development is occurring in select pockets of downtown/urban fringe markets where there is a perceived shortage of modern, prime assets, and this may put pressure on rents. If leasing these properties proves to be protracted, expect an uptick in downtown vacancy. In addition, as market demand moderates and construction costs rise, expect a slowdown in projects breaking ground.
- Investors Chase Returns as Yield Gaps Narrow: Investment in suburban assets in 2016 outpaced investment in downtown markets, accounting for 59% of the total sales volume. As yield gaps tighten due to rising inflation and increased finance costs, investors are selectively chasing higher yields. Additionally, several large suburban campuses were brought to market, boosting the suburban total. Nonetheless, institutional and cross-border investors are still attracted to trophy central business district assets with high-credit, long-term income streams. Low domestic bond yields continue to drive cross-border purchases.