Office Properties 2018

Online marketplaces like RealtyShares can allow investors to take advantage of investment opportunities across the spectrum of commercial property types.  One of the primary market sectors is that of office buildings, which can range from large multi-tenant structures in city business districts to single-tenant buildings that might be built to suit a specific lessee.  What seems to be in store for office buildings in 2018?

Office Buildings Are Different

Office space is driven by somewhat different factors than for other real property. Rents and valuations are primarily influenced by specific types of employment — those that utilize service and professional employees such as attorneys, accountants, engineers, insurance personnel, real estate brokers and related service providers (like title and escrow providers), and people working in banking, financial services, technology, consulting, medical, dental, and pharmaceutical fields. A region’s industry focus is thus key.

Office-Using Employment Growth

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Even though tenants often have solid finances and can sometimes afford to own their offices, like retailers these tenants look at their space as just another input in the production of their services sold from that location.  The office is just a factor affecting operating expenses and revenues, and is viewed more in the context of how the location might maximize profit — does the building really contribute to the company’s business, by (for example) allowing it to better advertise? Even if a business can occupy an entire building, it might still choose to lease in order to increase its operating flexibility; a corporate move otherwise becomes a difficult undertaking.  Thus, the vast majority of office buildings are leased, and not owned.

Office space rents vary by locations within office properties, and owners may charge premium rents for higher floors, building corners, and spaces contiguous with elevator banks.  Tenants often demand special features in the leases, including rights of first refusal to rent contiguous space, signage rights, or even building purchase options.  Office properties often have longer-term leases that can lag current market lease rates, so that “step-ups” (or, conceivably, step-downs) of rental rates are not infrequent when leases expire.

Despite the longer lease periods, office buildings have their own set of risks.  Economic downturns can affect commercial real estate — including office buildings — more than residential buildings, and businesses can go bankrupt even while people continue to need housing.  (After the early 2000s dot-com crash, for example, Silicon Valley rents dropped in some properties by more than 30%.)  For this reason, the credit quality of tenants is key; re-leases of office space can often require significant lead time to consummate.  Because of these issues, cash-flow oriented investors try to focus on office buildings with multiple tenants, so that no single tenant vacancy jeopardizes the entire property investment.

2018 – Markets Vary by Region, and Economic Base

New and different employment sectors and markets are driving the current office market.  The technology sector, for example, is now a key driver of office demand; CBRE reports that the technology sector has been responsible for nearly 20% of major office leasing activity in recent years.  This particularly benefits markets like the San Francisco Bay Area and Seattle, but the trend also aids emerging, lower-cost tech hubs like Charlotte and Phoenix.  The tech sector is expanding at about twice the rate of overall job growth, despite having slowed during the past few years.

Leasing Trends By Industry

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Rising Rents – But Higher Vacancy Rate, and Significant New Supplies?

Many market signals – such as increased employment rolls — point to a bump in office rental rates in 2018, says Bill Glazer, CEO of Philadelphia-based Keystone Property Group, a private real estate investment company that owns office and mixed-use properties along the East Coast. “When you take the sum  of those macro market impacts on the office sector, it does portend for a very strong 2018, and frankly 2019,” Glazer notes.

Vacancy rates stabilized from 2016 to 2017, then began to rise slightly toward the end of last year, says Peter Muoio, chief economist at Ten-X, an online real estate marketplace. Although there is expected to be economic growth in 2018, supply is growing in the office sector, Muoio notes. This is particularly the case in stronger markets such as New York City and Houston, which saw stronger economic recovery than what Muoio describes as “left-behind” markets, where there was no substantial recovery and higher office vacancies.

A lot of speculative office construction is underway, too.  According to Hans Nordby, managing director with research firm CoStar Portfolio Strategy, there is 120 million sq. ft. of office space under construction in the U.S., and of that, 40 percent is still available—the highest level CoStar has recorded in the last 13 years. According to Mr. Nordby, factors underlying the increased speculative development include cyclically low vacancy, rising demand for only class-A space and rents above replacement costs in many of the best locations.

Yet this new construction seems to have been concentrated in the strongest markets; the top five markets accounted for nearly half of all underway construction (on a square footage basis). Less expensive secondary markets are increasingly driving occupancy growth.

Although not a raging bull, the office sector in 2018 will likely continue to benefit from asset allocations that drive incremental capital to the sector, in tandem with the recent run-up in equities and commodities. More investors may also be drawn to real estate generally as an inflation hedge, as short-term interest rates remain below GDP growth rates and inflation expectations continue to rise.

 

Lawrence Fassler
Corporate Counsel
Lawrence has over 15 years' experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.
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