Office Construction Completions Expected to Hit Peak in 2017

Source: costar.com Written by Randyl Drummer

Vacancy Rates Likely to Increase in High-Construction Markets as Infusion of New Supply Hits Markets from San Francisco to New York City

Apple plans to start moving 12,000 employees into its new 2.8-million-square-foot "Spaceship" campus this year.
Apple plans to start moving 12,000 employees into its new 2.8-million-square-foot “Spaceship” campus this year.

Steady growth in office-using employment over the last few years and rising demand from big employers for a diminishing supply of newer high-quality office space have combined to create a fertile environment for new office construction, and developers are ready to deliver.

This year will likely be the peak in the cycle for the delivery of new office projects, according to CoStar Portfolio Strategy forecasts. The U.S. office vacancy rate has continued to steadily decline, moving from 10.7% in 2015 to 10.4% in 2016. Vacancies are expected to hold fast at 10.3% in 2017 amid ongoing demand for existing space from tenants, according to analysts presenting CoStar’s State of the U.S. Office Market Q4 2016 Review and Forecast presentation.

“The big news in 2017 for the office market is that we’re expecting a 55% spike in construction deliveries, increasing from 58 million square feet of new office space in 2016 to over 90 million square feet this year,” said CoStar Portfolio Strategy Director of Research/Office Walter Page, who co-presented the review and forecast with Managing Director Hans Nordby and Managing Consultant Paul Leonard. “While some of those will be projects that were pushed back from last year, we’re just at that point in the market cycle where it’s time for new supply.”

The hefty totals projected for this year are the result of the large number of new office projects started in 2015. The 129 million square feet of new office space started in 2015 included such massive mixed-use developments as 30 and 55 Hudson Yards, and the $1.2 billion One Manhattan West office tower in New York City. An even larger total of 138 million square feet of new office space was under construction as of Jan. 1 of this year.

For the most part, major construction is concentrated in a handful of large metros. New York City has seen a jump of 107% while Southern California, where construction has started to pick up substantially for the first time since the recession, is up 27% in two years time. Texas office construction is down 35% since 2015, largely due to the construction shutdown in Houston, where energy sector tenants have put large blocks of space on the sublet market.

The 138 million square feet under way is still significantly lower than the 2000-2001 period, when over 200 million square feet was under construction. This has allowed national office vacancies to remain well below long-term averages, Page and Leonard said.

“We’re expecting that 2017 will be a peak year for this cycle, but we’re not going back to the levels we saw during the last cycle,” said Leonard.

That being said, most large markets are seeing construction levels as a percentage of total office inventory that are well above their historical averages. In the San Jose market, for example, construction totaling 9% of total office inventory, 10 million square feet, is under way, compared with 1.4% nationally. While pre-leasing is quite strong, potentially rising levels of backfill space that may become available when companies move into their new quarters is a concern, Leonard said.

New York City, which rarely registers among the construction growth leaders based on percentage of inventory due to the massive size of its base, currently has 19 million square under way, with the massive Hudson Yards comprising roughly half of that total.

“The Hudson Yards project alone is almost equivalent to the entire under-construction supply in the San Jose market,” Leonard said.

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The impending wave of new supply will have an impending ripple effect on demand fundamentals such as net absorption, occupancy and rental rates in several large markets in coming quarters. Absorption totals for newer 4 and 5 Star office properties, which has fallen from 64 million square feet to 42 million square feet nationally over the past year, is expected to rise this year as several large build-to-suit projects, including large projects by Google and Apple, including Apple’s 2.8 million-square-foot “spaceship” headquarters campus, finally reach completion.

Office vacancy rates for newer buildings could shoot up to 25% in San Francisco, while vacancy rates for newer vintage buildings could potentially double in Denver and rise significantly in New York City and Los Angeles.

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Meanwhile, high levels of construction in CBD submarkets are causing rental rates in the urban core to slow, narrowing the rent gap between downtown and suburban properties. In markets like Chicago, downtown construction comprises 75% of total construction within the entire metro, while urban core property makes up 40% of total stock within the Chicago metro. The same trend is occurring in New York City, Denver, Seattle, Washington, D.C. and Los Angeles, restricting rental rate upside in those CBDs.

“High levels of construction are beginning to put a limit on rent upside,” Page said.

However, strong demand growth markets that have had relatively little construction since 2006 such as Tampa, Orlando, Minneapolis and San Diego may present windows of opportunity for developers. But that window could close fast.

“The next developer to build a building in those markets is probably going to do pretty well, but for the third or fourth outfit, they’re probably too late,” Nordby said.

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