What Makes An Office Market Great?

Although many office markets in the U.S. have felt the bite of the pandemic, others are doing relatively well. For the country as a whole, asking rents for office space and rent growth are on the rise, despite increasing vacancy rates and negative net absorption.

Over the next 12 months, office-using employment is projected to increase. However, some office markets will likely perform better than others. In this article, we’ll discuss why some office markets are better than others, and how office landlords can choose winners and avoid the losers.

2021 Office Market Outlook

The 2021 U.S. Real Estate Market Outlook from CBRE reports that while the deteriorating office market fundamentals that have impacted many cities should begin to stabilize next year, some markets will outperform others.

Markets to watch

Dense urban areas such as San Francisco and New York City that have a high dependence on mass transit will have a slower recovery. Business-friendly secondary markets in the Southeast such as Raleigh-Durham, Charlotte, and Tampa will benefit from resilient demand for office space, lower costs, and consistently positive demographic and employment growth.

Flight to quality

Class A office properties are likely to experience much faster improvement in demand, vacancy, and rents as the recovery begins to accelerate in 2021. Tenant expectations are likely to change, with increasing demands for flexible space options, improved indoor air quality, and touchless technology. Office buildings owners who invest the capital to provide these amenities may attract a larger share of enterprise and credit tenants as leasing activity resumes.

Impact of working from home

CBRE believes that the effect of working remotely on overall demand for office space may not be nearly as negative as some other analysts believe. In fact, Colliers International predicts that the number of coworking and flexible office workspace locations will double or even triple within the next five years. While long-term trends are difficult to predict, what is likely is that companies may favor a hybrid work style that combines remote working with office use.

Why Some Office Markets Outperform Others

According to the 2021 Emerging Trends in Real Estate report from PwC and ULI, one of the biggest challenges facing commercial real estate investors this year has been to separate the short-term trends the pandemic has instigated from the long-term investment potential of office property.

To help select winning real estate markets and avoid the losers, there are two main steps office property investors can follow. First, consider the most important issues for the market overall. Then, look at the specific factors that help make an office market great.

Issues for real estate investing in 2021

The most important issues for real estate investors to consider when choosing a market to invest in can be divided into three categories:

Economic and financial issues

  • Job and income growth
  • Capital availability
  • Interest rates and cost of capital
  • Global economic growth and affect on the local market
  • Qualified labor availability
  • State and local taxes

Social and political issues

  • Effectiveness of local response to epidemics and pandemics
  • Political landscape
  • Housing costs and availability
  • State and local budget surpluses or shortfalls
  • Income and racial inequality
  • Immigration

Real estate and development issues

  • Construction and labor costs
  • Cost of building supplies and materials
  • Construction labor availability
  • Tenant leasing and retention costs
  • Land costs, property taxes, and total operating costs
  • State and local regulations toward business

Factors that make an office market great

The above factors can provide a macro guide to selecting the best real estate markets for investment. Once the choice of markets is narrowed down, investors should consider some of the key criteria that make an office market great.

Minimal dependence on public transit

Transit-oriented office markets such as New York City, San Francisco, Boston, Seattle, Chicago, and Philadelphia are unable to handle large volumes of automobile traffic in place of mass transit. In many urban areas, expanding the highway and freeway systems simply is not possible.

Although many of these markets are top job creators, the pandemic has accelerated the shift to smaller secondary markets such as Tampa/St. Petersburg where companies can lease affordable office space in the top buildings and best parts of town. This helps to keep the demand for office space strong, and allows businesses to attract and retain skilled talent in a business-friendly city with an affordable cost of living and better quality of life.

Shift to secondary markets

Office investors are favoring less expensive secondary markets and urban submarkets with the potential for continued long-term growth after the pandemic ends and the economy continues to recover. Smaller metropolitan areas and urbanized submarkets of larger cities have many of the same amenities that central business districts offer, but without having to rely on public transit.

Secondary markets that create jobs and are places where people want to live will continue to be attractive in the long term. Markets such as Tampa are more accessible, with a local government that has shown its ability to support growth. The shift to secondary markets is also driven by the fact that millennials are migrating from gateway cities to smaller markets where renting is more affordable and buying a home is still within reach.

Investment fundamentals

The pandemic has created uncertainty for office building investors in a variety of ways. There is still the question of when workers will return to the office, and the number of physical changes needed to make office buildings healthy and drive future leasing activity.

Despite these question marks, ULI notes that the market remains liquid for high-quality office properties that are well leased.

Investors who currently own and operate office buildings may also benefit from the slowdown in speculative construction as lending becomes more restrictive. As the economy recovers and the demand for quality office space increases, office owners may benefit from a shortage of supply as more tenants look for space to lease.

By reviewing the most recent U.S. Office MarketBeat report from Cushman & Wakefield, investors can learn where the investment fundamentals for office space are strong, and where demand for office space is likely to grow. The following key demand indicators from Q3 2020 help to explain why the demand for office space in Tampa and St. Petersburg remains strong:

Tampa
  • Leasing activity: 2,383,143 SF YTD
  • Overall vacancy: 12.1% as of Q3 2020
  • Asking rents: $31.93 PSF Class A office space
  • Inventory: 31,907,494 SF
  • Deliveries: 422,022 SF YTD
  • Under construction: 1,107,000 SF as of Q3 2020
St. Petersburg
  • Leasing activity: 484,411 square feet YTD
  • Overall vacancy: 11.0% as of Q3 2020
  • Asking rents: $25.03 per square foot Class A office space
  • Inventory: 11,566,894 SF
  • Deliveries: 0 SF YTD
  • Under construction: 0 SF as of Q3 2020

Top U.S. Office Property Markets

The Urban Land Institute counts the Tampa metro area as one of today’s top four boom markets. Boom markets are ones that have less exposure to industries affected by the pandemic. They are also more affordable places to live and do business in with pro-growth governments and a better quality of life.

Super Sun Belt cities

Super Sun Belt cities are magnet markets where population and business growth are faster than the U.S. average. These metropolitan areas are still affordable for businesses and residents, even as the booming economies continue to attract a wide range of businesses:

  • Atlanta
  • Dallas/Fort Worth
  • Houston
  • Phoenix
  • San Antonio
  • Tampa/St. Petersburg

These six Sun Belt cities are projected to generate 28% of the new jobs in the entire country over the next five years. Two of the Sun Belt markets – Tampa/St. Petersburg and Dallas/Fort Worth – are ranked in the top 10 for overall real estate prospects, an indication of the tremendous draw and appeal these cities continue to have.

Best office markets to buy and hold

The 2021 Emerging Trends in Real Estate report from PwC and ULI interviewed and surveyed nearly 2,000 real estate investors, developers, fund managers, lenders, brokers, and consultants.

According to these industry experts, the top office markets rated for buy and hold investment are:

  • Austin
  • Boise
  • Boston
  • Long Island
  • Madison, WI
  • Nashville
  • Salt Lake City
  • Tampa/St. Petersburg
  • Washington, DC – Northern VA
  • West Palm Beach

Factors to Consider Before Investing in Office Buildings

In some select markets across the country, such as Tampa/St. Petersburg, the investment fundamentals for office buildings remain strong. The long-term potential of Class A office buildings in Tampa can provide strategic opportunity to geographically diversify a property portfolio while generating healthy potential returns.

However, even within the same market or submarket, not all office buildings offer the same balance of risk and reward. There are several key factors to consider before investing in office buildings:

Special characteristics of office assets

Some of the most important and unique characteristics to think about include:

  • Location: Central business district (CBD) vs. suburban submarkets, and the economic and population characteristics of the specific area
  • Building type: Single-tenant vs. multi-tenant and low-, mid-, or high-rise office building structures. Single tenant buildings are easier to manage but become risky at lease expiration.
  • Class: Office buildings are generally categorized as Class A, B, or C, with Class A office property normally attracting the best tenants and highest rents
  • Tenant type: Common users of office space include professional services, technology, healthcare, and government
  • Tenant credit quality: Credit tenants can be local, regional, or national and are judged to have the highest quality and lowest potential risk, with office buildings leased to credit tenants having higher values with more secure lease payments

Understand local area demographics and economic trends

The demand for office space is affected by a variety of factors including population and job growth, cost of living and doing business, and the overall quality of life.

Over the past several years, people and businesses have been moving from dense major urban areas to smaller secondary and tertiary markets. This trend has been accelerated by the pandemic.

Transit-dependent cities such as New York, Chicago, and Los Angeles are seeing negative net migrations, while business-friendly areas like Charleston, Nashville, and Tampa are benefiting from positive in-migration from different parts of the U.S. and other countries.

Monitor leasing trends and sublease space available

Covid-19 and the economic recession are also changing the way office space is leased. Many office tenants today do not want longer leases, creating a disconnect between office landlords and occupiers. Experienced office building owners and managers are taking this opportunity to sign new leases with quality tenants, grow market share, and increase cash flow.

The amount of office space available for sublease in some markets can also create a significant impact on asking rents, in some cases shifting negotiating power from the landlord to the tenant.

Sublease office space is created when tenants who have existing leases downsize or completely go out of business, and try to sublease their space to another business in an attempt to generate some income from their vacant space to help pay the rent due to the landlord. Office markets where the economy is strong and growing generally see less sublease space, while cities that are struggling see more office sublease space come to market.

The most recent Sublease Activity Report from Cushman & Wakefield notes that 70% of the office markets have recorded an increase in sublease space through the first half of 2020.

For example, some large urban areas like San Francisco and Phoenix have seen sublease space as a percentage of total vacancy increase by more than 190% compared to the end of last year. On the other hand, office markets such as Tampa/St. Petersburg have seen office sublease space actually decrease over the same time period. This is one of many indicators that the demand for office space in the Tampa metropolitan area continues to grow.

Conclusion

The Urban Land Institute notes that significant opportunities to operate and manage office buildings more efficiently lie ahead.

However, smaller and more nimble companies are the ones that may create more efficient and forward-looking office property investments in the future.

While large commercial real estate firms have multiple layers of people and teams that make them less nimble, experienced local owners and operators of office buildings are in a better position to make the most of opportunities as they arise.

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