During the recent 2008-2010 downturn, office vacancy climbed to 18%, which is not far from previous highs in 1992 and 2002. Given the unprecedented level of job losses in the Great Recession, 2.3 million office-using jobs and 8.4 million total jobs, the office vacancy rate should have risen far more. The more moderate downturn was due to two important factors. One, going-in vacancy rates that were relatively low, especially compared to the late 1980s (12.3% as of YE 2007 vs. 18.9% as of YE 1989) and two, going-in construction that was also significantly less (55 to 60 million square feet in 2006-2007 vs. 120-13 million square feet in 2000-2001 and 130-140 million square feet in 1988-89).  

Although it may not quite feel like it yet, the relatively low vacancy rates and significantly less construction prior to the downturn should hasten office recovery, creating strong investment opportunities.

As of Q4, 2010, the nation began to witness moderate positive net absorption once again and effective rents stabilized. Assuming that the economy continues to expand by at least a moderate pace, we should witness a drop in vacancy of approximately one percentage point in 2011 and a 3 percentage-point drop by 2012, placing the national vacancy rate at less than 15%. A moderate economic expansion would also enable modest rent growth of 2% or 3% in 2011, leading to robust rent growth of 5% to 7%, starting in 2013 as vacancy moves closer to the low double-digit benchmark.

Another positive sign for the office market is the gap between cap rates and interest rates.The current 500 bps spread between office cap rates and interest rates is the widest of any period since 1990, pointing to a strong “buy” signal for the sector. Locking in today’s low interest rates ahead of rent growth, improvement in values and dearth of new construction starts should lead to out-sized gains through 2015. But which markets are likely to lead or lag?

The current lack of construction activity makes high-beta MSAs—MSAs with generally strong growth in employment and in office demand during economic-recovery years— particularly attractive acquisition targets. In previous recoveries, these were the markets that came back first and strongest. Better yet, many of these high-beta MSAs currently have “only moderately high” vacancy rates, 15% to 20%, and history has shown that rent spikes of 8% or more can occur in high-beta markets once vacancy drops below 14%. MSAs with this combination of conditions include Charlotte, Houston, Miami, Raleigh-Durham, Orange County, Salt Lake City, San Diego, San Francisco and Seattle.

High-beta cities that will likely lag behind, due to high—north of 20%—going-in vacancies, include Atlanta, Austin, Dallas, Denver, Oakland/East Bay, Phoenix and San Jose. A rapid tightening in these MSAs appears probable, but rent-spike territory will have to wait until approximately 2014-2016. Any play in most of these MSAs, other than the ones in the San Francisco Bay Area, however, should be considered short-term plays, due to the risk of large amounts of construction kicking in as soon as market conditions tighten, particularly since construction financing will likely be more easy to obtain than it was pre-2014.

A third batch of MSAs appears attractive, particularly for long-term holds. These are moderately strong and growing coastal MSAs in the West or along the Atlantic Seaboard. These MSAs also have shown the capability of rent growth north of 8% in recovery years, albeit, starting approximately a year later than in high-beta cities. A number of these MSAs also currently also have “only moderately high” vacancy rates, of 10% to 15%. These markets include Boston, Los Angeles and New York.

Hessam Nadji is managing director, research and advisory services, for Marcus & Millichap Real Estate Investment Services. Contact him at [email protected].