Morningstar recommends investors continue focusing on core markets such as Los Angeles.

LOS ANGELES—Demand for office space continued to improve in the first quarter, says CBRE Group, with eight out of 13 major metro markets seeing vacancy fall and average asking rents increase. “The US economic recovery is continuing to fuel demand for office space nationally; with relatively little new space coming on the market, landlords are seeing the pendulum of pricing power shift in their direction and are able to raise rents modestly in most major markets,” says Art Jones, senior managing economist at CBRE.

The fact that this recovery has occurred more gradually than many would have liked has worked in favor of ownership, writes Todd Lukasik, a senior analyst with Chicago-based Morningstar Inc. “Many have been longing for an increase in economic growth in the United States, but the slow and steady economic recovery has actually been very good for landlords, in our view,” he writes.

While “slow and steady economic and job growth” means equally measured increases in demand for commercial real estate, “the macro economy is not improving enough for developers to aggressively add incremental supply to commercial real estate stock,” Lukasik writes. Accordingly, “existing landlords should continue experiencing improved occupancy rates, greater bargaining power relative to tenants, and nice increases in same-store net operating income. While we’ve seen some pickup in new developments among certain property types and in certain markets recently, to the extent that the slow and steady recovery continues, we think landlords will continue to enjoy a generally favorable environment.”

When those landlords happen to be REITs, as many large-scale owners are, Lukasik cautions “the prospect of higher interest rates remains a risk to REIT valuations. As rates on the US 10-year Treasury have risen, REIT stock prices have generally fallen.”

Hardest hit among REIT stocks, he adds, “were some of our favorite firms that use long-term lease structures, as their rental streams generally cannot quickly reset higher” amid an inflationary environment. “Although rising interest rates might signal a strengthening economy, which could benefit real estate fundamentals, we do not expect the macro environment to improve enough to offset what could be another 125-basis-point (or more) rise in rates to levels nearer historical norms,” Lukasik writes.

For REITs and other sizable investors, there’s an increasing impetus to look at secondary markets, where the CRE recovery has begun to spread. Nonetheless, Lukasik writes that in the view of his firm, “concentrating on the gateway markets—where favorable demographics promise rising long-term demand for real estate while permitting, space constraints, financing, and other challenges can effectively limit the construction of competing supply—is a solid strategy that can form the basis of an economic moat.”

CBRE says Atlanta and Seattle led the way in vacancy declines during Q1, with each seeing a 60-bps drop. “Technology firms once again led demand improvements in Seattle as the local economy continued to fire on all cylinders,” according to CBRE. In Atlanta, “the story was more broad-based” with tech, healthcare and service firms driving demand. Phoenix and San Francisco led the nation with asking rent increases, at 3.9% and 3.3.%, respectively, during Q1.