The office sector's fundamentals appear to be stalling after years of slow recovery, as vacancy rates have plateaued despite a healthy labor market and growing national economy, according to online real estate marketplace Ten-X's outlook for 2017.
Portland, Ore., Oakland, Palm Beach, Fla., Orange County, Calif. and Miami are the top markets in which investors should consider buying office assets this year. These regions, concentrated in Florida and the West Coast, are being fueled by growing economies, where strong demographics and consistent job growth are fueling robust demand for office space.
Meanwhile, Houston, Cleveland, Memphis, Milwaukee and Southern Maryland are the top markets where market conditions might cause office investors to consider selling their properties. These cities are being undermined by weakening labor markets, which have reduced demand for office space and significantly slowed absorption rates.
According to Ten-X, Reis data shows the national vacancy rate measuring steady at 16 percent for three consecutive quarters. While vacancies are now 40 bps lower than a year ago and 160 bps below their cyclical peak, they remain well above levels seen during the last economic cycle.
The slowdown can be traced to weak absorption, as only 70 million square feet of new supply has been occupied during each of the last two quarters. Rent growth has hit a similar slump, with effective rents edging up just 0.4 percent in the third quarter and 2.8 percent over the past year – the slowest annual growth since mid-2014.
The downturn comes despite a strong labor market that continues to add jobs and a steadily expanding economy. Low unemployment, consistent payroll gains and rising wages should offer a boost to overall demand for office space, though the national economic picture is marked by stark differences among markets in different regions, according to Ten-X Research.
Although the office sector still faces significant long-term headwinds driven by the rise of shared offices, cloud computing and remote teleconferencing, Ten-X models project moderate improvement as the current economic expansion advances. Cyclical factors are expected to drive vacancies to a low of 15.3 percent in 2018 before regressing to roughly 17.6 percent during a downturn scenario in the following two years.
Rent growth is also projected to emerge from its cooling period to post roughly 3 percent increases per annum from 2017-2018, reaching a peak of over $27 per square foot before contracting as vacancies begin to rise again.
"After a long, gradual recovery following the last recession, the office sector has seen its progress slow significantly over the last year. While it faces long-term challenges as technology increases the viability of non-traditional working arrangements, the resilient economy makes it likely that the current malaise is only temporary," said Ten-X Chief Economist Peter Muoio. "Overall demand should increase as employers continue to add jobs over the next two years, which bodes well for investors' long-term prospects in most areas of the country."
Overall investment sales volume in the sector totaled $35 billion during the third quarter of 2016. Effective rents are up 2.8 percent and have now surpassed their pre-recession peak, while cap rates rose 20 bps to average 6 percent.
TOP FIVE BUY MARKETS
1. Portland, Oregon
2. Oakland, California
3. Palm Beach, Fla.
4. Orange County, California
TOP FIVE SELL MARKETS
2. Cleveland, Ohio
3. Suburban Maryland
4. Memphis, Tenn.