Office Sector Recovery Elusive, Ten-X Says in Report

Office Sector Recovery Elusive, Ten-X Says in Report

open-office plan

Rent growth in the office sector is losing steam, according to the latest U.S. Office Market Outlook from Ten-X Commercial, a leading U.S. online and only end-to-end transaction platform for commercial real estate. Ten-X’s analysis shows office completions outpacing net absorption for the fifth consecutive quarter, reflecting changes in how companies utilize office space as well as certain markets’ economic strength.

Noting a “general malaise” in the national office sector, Ten-X Chief Economist Peter Muoio said: “Strong markets with fast-growing economies saw significant development and are now grappling with increased supply, while weak markets continue to languish due to their struggling local economies. In most markets, technological innovation is an additional factor that acts as a headwind for the office sector.”

One major trend is shrinking office space requirements, as companies fit more workers into open-office plans, more employees are working remotely and cloud computing is reducing the need for space-eating filing cabinets and computer servers.

Still, there are markets where it makes sense to consider buying office properties, Ten-X says. Among the top markets showing strong overall economies and job growth within specific sectors are Nashville, Kansas City, Washington, D.C., Sacramento and Oakland.

On the flip side, the top markets where conditions might cause investors to consider selling their office properties include Milwaukee, Suburban Maryland, Chicago, Austin and Baltimore, according to Ten-X.

 

Office Sector Recover Elusive; Vacancy Rate Inches Upward

 

Vacancies in the nation’s office sector inched up to 16.5 percent from the low to mid-16 percent range in the first quarter of 2018, where rates have been mired for nearly three years, Ten-X says. Rent growth is around 2 percent, down from the 3.8 percent mark set in 2015.

Ten-X predicts absorption will fall further in 2019 and 2020, pushing the vacancy rate to 18.7 percent before a recovery begins in 2021.

“The Ten-X Commercial ‘heat map’ is overwhelmingly red and pink, which reflects the vulnerability of the office segment across the country,” said Muoio. “While every submarket and individual asset tells its own story, it’s clear that the overall picture for the office sector is decidedly bleak.”

From Ten-X, here is a closer look at the top five “buy” and top 5 “sell” markets:

 

The Office Sector’s Top Five ‘Buy’ Markets

Nashville

Nashville’s expansion continues unabated and the city’s office market remains solid. Employment in the city has been exhibiting growth in the 2 percent range for the past eight months and total employment recently surpassed the 1 million mark. The office-using professional and business services sector continues to fuel the economy with gains in the 5 percent range. Unemployment is at an extremely tight 2.8 percent and population is expanding at twice the national rate. Per Reis, Nashville’s effective office rents are still strong although year-over-year growth slowed to 3 percent. In the event of Ten-X Commercial’s modeled downturn, Nashville would prove resilient. In 2021, office rents are projected to end 2.6 percent higher than their current mark. NOI is expected to rise 0.5 percent annually throughout the forecast period, with gains in 2018 and 2021 bookending 2019-2020 declines.

Kansas City

Kansas City’s economy continues to make plodding progress, which should make the office market resilient in the event of a downturn. The city’s economic growth has been remarkably consistent, if unspectacular, with annualized gains in the 1 percent range since the beginning of 2017. Kansas City’s unemployment rate is 3.3 percent, below the national average, while population growth is a healthy 1.1 percent. In the first quarter, effective rents grew to 3.1 percent year-over-year, although the vacancy rate was 60 bps higher than its Q1 2017 figure. Taking into account the Ten-X Commercial stress test scenario in 2019 and 2020, rents would end 3.5 percent higher in 2021 than their current mark. NOIs are projected to rise steadily and consistently except in 2019, climbing 0.9 percent annually through 2021.

Washington, D.C.

Thanks to slow-but-steady economic expansion and robust population growth, office rents in the Washington, D.C. market are rising. D.C.’s office vacancy rate measured 10.4 percent in the first quarter of 2018, down 50 bps from their cyclical peak. Effective rents grew 1.3 percent year-over-year, per Reis. In the event of a modeled downturn in 2019-2020, office rents should end the forecast period 3.4 percent higher than their current mark, as this market typically has low cyclicality. NOI will make 0.5 percent annual gains through 2021, with 2018 and 2021 gains bookending 2019-20 declines.

Sacramento

In Sacramento, a massive government sector and fast-growing education and healthcare sectors are fueling a robust economic expansion. As such, the city’s office market has made impressive progress throughout this cycle. Sacramento’s office vacancy rate stood at 19.3 percent in the first quarter of 2018, unchanged from a year ago and down 210 bps from its cyclical peak. Effective rents rose to 2.9 percent year-over-year. In the event of an economic downturn, Sacramento would prove more resilient than most cities, with rents still forecasted to climb 0.5 percent by 2021, even as vacancies edge up by 80 bps. NOI is projected to maintain 0.3 percent annual growth throughout the forecast period despite likely declines in 2019 and 2020.

Oakland

Key sectors, including professional/business services and construction/mining, are fueling a healthy economic expansion in Oakland. The local unemployment rate is in the upper 2 percent range and the population’s growth rate of 0.7 percent remains on par with the national average. Oakland’s office vacancy rate was at 14.1 percent in the first quarter of 2018, 20 bps lower than a year ago and a full 640 bps below its cycle peak. In the event of a recessionary scenario, rents would finish the forecast period 0.1 percent higher than where they currently stand, while vacancies would edge up to 16.2 percent. NOI is expected to fall 0.1 percent annually through 2021, due to declines in 2019 and 2021.

The Office Sector’s Top Five ‘Sell’ Markets

Milwaukee

Milwaukee’s weak economic growth is straining the city’s office market. Employment growth has been persistently weak since 2016 as the outsized education and healthcare sectors, as well as the wholesale trade sector, have continued to disappoint. The office vacancy rate measured 19.7 percent in the first quarter of 2018, up 50 bps year-over-year and marking a cyclical peak. While effective rents rose 1.9 percent year-over-year, they are expected to decline by 3 percent by 2021. Vacancies are projected to climb by 180 bps, ending the forecast period at an alarming 21.5 percent. NOI will fall 1.2 percent annually through 2021.

Suburban Maryland

The economy of suburban Maryland is losing steam and its office market is beginning to decline. The region’s important government sector is showing disappointing performance this cycle, with annualized gains ranging mostly between 0 and 2 percent. The area’s office vacancy rate measured 18.2 percent in the first quarter of 2018, unchanged from a year ago. However, in the event of a modeled downturn, Suburban Maryland would suffer with office rents ending the forecast period 2.1 percent lower than their current mark. In turn, vacancies are expected to rise to 20.7 percent by 2021. NOI is expected to decline annually by an average of 1.2 percent through 2021, with 2018 gains likely to be erased by economic contraction in 2019 and 2020.

Chicago

Chicago’s poor demographic figures, namely population outflows that have persisted for the past three years, are hampering the metro’s economic outlook and making its office market more vulnerable to cyclicality. The most recent data shows population fell 0.2 percent in 2017 — the third consecutive year of population outflows. Chicago’s office vacancy rate measured 17.8 percent in the first quarter of 2018 and it is expected to finish 140 bps higher by 2021. Office rents are expected to decline by 3 percent over the four-year period. While NOIs are expected to tick up in both 2018 and 2021, declines in 2019 and 2020 will average out to a 1.1 percent annual loss.

Austin

Despite a red-hot local economy which has notched 3 to 4 percent annual growth in recent years, Austin’s office market is set for a severe downturn. Underscoring Austin’s rise to prominence as an economic and cultural center, its population is booming. In the first quarter, the city’s office vacancy rate recorded a year-over-year decline of 50 bps, and effective rents rose 3 percent. However, in the event of a downturn, rent growth would slow and vacancies would jump to 18 percent by 2021, as increased supply meets reduced demand. Ten-X Commercial forecasts NOIs to decline 1 percent annually through 2021, as 2018’s gains would likely be offset by declines for the rest of the forecast period.

Baltimore

Baltimore’s economic indicators paint a weak growth picture, prompting concerns about the resilience of the local office market in the event of a recessionary stress test scenario. In the first quarter of 2018, Baltimore’s office vacancy rate was 17.1 percent, 80 bps higher than a year ago. By 2021, vacancies could rise further to 19 percent. While effective rents rose 1.7 percent year-over-year, per Reis, rents are projected to decline by 2 percent over the next three years. NOIs are expected to post 1 percent annual losses through 2021, with declines in 2019 and 2020 bookended by gains in 2018 and 2021.

 

To read the Ten-X news release about the report, click here.