The New Normal for Office Fundamentals

Editorial|&utm_term=|Website-Editorial-NAT%28Website%29|"> Auction.com's chief economist Peter Muoio tells GlobeSt.com exclusively that we may be seeing an echo of the mid-2000s. We spoke with Muoio about the rebounding office market and what we can expect to see in terms of office fundamentals for the next couple of years.

GlobeSt.com: With some observers pointing to a rebounding office market, what will be the new normal for rents, vacancies and sales volume?

Muoio: We have this cyclical tailwind. The economy is stronger, and the last few months have been very strong—we're adding something like 300,000 jobs per month nationwide—and yet we have this headwind coming from the workstyle and technology changes we've been facing. That said, our forecast for office is pretty robust. Right now, basically there's very little being developed, and in office, the lead time between start and completion is a couple of years, which gives you a known window of very limited supply, amid a better tailwind from the business cycle. This suggests acceleration in improvement of office vacancies. Office vacancies ended 2014 at 16.7% according to Reis, and we're expecting them to be down to 14.8% by 2018. This is a nice improvement, but the low point in the previous cycle was at 12.6% in 2007 and at 12.3% in 2000. So, we're sort of ending up at higher vacancies each time, not fully getting back to where we were before the cycle began.

There's also a huge bifurcation between the CBD and suburban-office markets. We're stuck in many of these suburban situations where there's outdated space that's difficult to lease in its current form, and there are not a lot of companies looking for a whole building in, for example, suburban New Jersey. The owner has to think about if it would be easy enough to turn it into a multi-tenant office or turn it into something else completely. Some of this space will be re-used in other kinds of ways to help vacancies come down, but these problems are separate from cyclical ups and downs.

With regard to sales volume, there does seem to be something of an echo going on between the previous cycle and the current cycle in the sense that in 2016 and 2017 we're likely to see bigger increases in transaction volume. This is tied in with the maturity of the loans that were done 10 years ago, which was at the peak of transaction volume in that cycle. There will be a bigger jump in 2016 and 2017 that will be an echo of what happened before.

On a national level, we're expecting rents to surpass their pre-recession peaks this year, but right now they're still below where they were in 2007. We will see acceleration, but not a super-healthy level of office rent growth as those vacancies come down.

GlobeSt.com: What will landlords do with this rebounding market once they get the upper hand?

Muoio: Their hand will get better in some markets, like Silicon Valley, and they'll increase rents. But there is a distinction between hot markets where landlords have the upper hand and other markets where there is a lot of availability.

GlobeSt.com: Will landlords continue to work with tenants the way they did during the recession?

Muoio: It's a market-driven thing, but I think in the markets that are slower to recover, landlords will work to get those buildings occupied.

GlobeSt.com: How will ground-up construction affect the sector as a whole?

Muoio: Again, it's really market specific. Our overall forecast for completions is really very minimal. However, those minimal completions are going to be dominated by a few markets. For example, Houston is a hot market that has been doing really well, and development is taking place there. There are significant completions expected there over the next couple of years. But our expectation because of energy prices is that the demand side will ease off in Houston. As a result, we'll have the demand side simmering down and the supply side ratcheting up and vacancies moving in the other direction for a while. In 2017 and 2018, some planned and proposed projects will likely get delayed until demand comes back again. We will have a few markets like that on the energy front, but otherwise development is really concentrated in the hot markets.