by David Rubenstein and Brandon Huffman
The current U.S. office market environment can be one of opportunity for investors where fundamental supply/demand dynamics for office space appear robust, keeping in mind potential risks are ever present. The United States has recovered 196 percent of the office-using jobs lost in the recession of 2008–2009, and new supply of office space is limited, especially outside of CBDs and technology-driven submarkets. Broadly speaking, these dynamics favor absorption of office space to house new employees, in tandem with rent growth driven by supply constraints.
At the same time, emerging dynamics have made the recovery slower and also moderated expectations for space absorption and rents over the long term. We believe office tenants are using space much more efficiently under new leases, so employment growth and recovery of the magnitude experienced to date does not translate into as much positive absorption as might be expected based on past metrics.
The same trend toward space efficiency, barring an unforeseen reversal, should continue to affect overall absorption for the foreseeable future as long-term leases gradually roll. This modest but significant downward pressure on space absorption and rental rates certainly should factor into any current analyses of the market or individual investment opportunities.
And, of course, these broad dynamics in the U.S. office market as a whole may play out very differently in various MSAs and submarkets, so investors looking for opportunities must layer thoughtful micro-analysis over macro trends. Also to be considered are the tastes of today’s capital markets. In our opinion, tech-oriented office markets, in many instances CBDs that cater to millennial workers, are strongly favored, while traditional office markets — particularly suburban areas — are overlooked or outright rejected by investors because of a lasting perception they are laggards. The interests of global capital frequently translate into real-world effects on pricing and competition for deals.
Equilibrium
Office investment, and particularly value-added investment, requires a grasp of market equilibrium — in terms of vacancies and rents — and whether we are below, at or above equilibrium at any given time. Our view is rents rise and fall cyclically, sometimes rapidly, but ultimately revert to an equilibrium level that rises slowly over time. Value-added office investment opportunities may be indicated during periods where rents are below the long-term equilibrium and, thus, potentially offer the maximum opportunity for rent growth as rates rise toward equilibrium levels. Equilibrium vacancy level is also a key reference point because vacancy rates are one of the major drivers of rents. So, how are vacancies and, therefore, rents affected by the powerful forces of job creation and simultaneous reduction of space usage due to efficiency?
The bubble and the bust
Office rents shot up with incredible speed from 2005 to 2008, rising approximately 30 percent in these few years (versus a 3 percent annual rent growth rate that we consider a reasonable norm), while the overall vacancy rate nationwide dipped to 13 percent.
In our opinion, the United States was in an office rent bubble, which, along with an abundance of debt and equity capital, aggressive underwriting of future rents, and a general dismissal of real estate risk, led to a valuation spike in the office sector of more than 60 percent. But in this case, what went up came down quickly. Between December 2007 and December 2009, the U.S. economy lost 8.6 million jobs, including approximately 2.3 million office-using jobs. The nationwide vacancy rate exceeded 17 percent by early 2009 and, by metrics that account for space leased but not in active use (what we call “phantom vacancy”), we believe may have approached 20 percent.
Jobs return, but office space absorption lags — why?
To predict the pace of recovery, an office investor might have asked: How long will it take to replace the office-using jobs that were lost in the recession? With that information, perhaps the investor could predict the timing of the reversion to equilibrium vacancy or below, and the period of rent growth that should accompany that reversion. In the current cycle, that question would have yielded a dramatically wrong answer because of the wild card of space efficiency. This phenomenon, if it continues, should be an ingredient of office market analysis for the foreseeable future.
As of June 2016, the United States had recovered 196 percent of the office-using jobs lost during the recession. Under the previous model of space usage per employee, an investor might have expected the 4.5 million office-using jobs created between 2010 and second quarter 2016 — far more than the 2.3 million office-using jobs lost in the recession — to result in absorption of 990 million square feet of office space and lead to approximately 10.5 percent availability. This level would have been significantly below what we would consider equilibrium.
In reality, things did not play out that way. Under the new paradigm of space efficiency, we believe tenants have been allocating approximately 20 percent less space per employee, putting downward pressure on demand and absorption at the same time jobs are being created. Assuming all tenants ultimately implement space efficiency, which remains to be determined, 20 percent less space per employee and an 80 percent overall occupancy would translate into a 16 percent total reduction in demand for office space. This kind of change does not happen all at once. With long-term leases being the norm, in our opinion, this 16 percent reduction will be felt over approximately 20 years, at a rate of 0.8 percent per year, as tenants gradually reconfigure their space.
But if we break out the six years since the start of the economic recovery, it is easy to see how space efficiency already has affected the market’s march back to equilibrium. If we assume 0.8 percent less absorption per year — or said differently, 0.8 percent per year additional supply shed back onto the market since the space efficiency paradigm has taken hold — over six and a half years, we have an overall reduction in absorption of 5.2 percent. Not coincidentally, if you sum the 10.5 percent “expected” availability rate based on old space-usage patterns and post-recession job recovery, and the 5.2 percent reduction in absorption due to space efficiency, you arrive at 15.7 percent — a good approximation of today’s national availability rate, when you include a 2.3 percent phantom vacancy factor on top of the broker-reported national statistics. In other words, we believe space efficiency may be contributing to continued high availability and slower absorption.
Absorption and supply trends going forward
If we assume the economy continues to create 200,000 jobs per month and 2.4 million jobs per year — below 2014 and 2015 averages but above normal job growth — we arrive at 744,000 office-using jobs added per year (based on 31 percent of new jobs falling in the office-using category). Under the new paradigm of space usage per employee, we would expect this level of job growth to result in 160 million square feet of office absorption annually. But space efficiency can be expected to contribute about 90 million square feet, or 0.8 percent, of new availability to the market annually, as tenants continue to reconfigure their space as leases roll. This could result in expected net annual absorption of 70 million square feet under the new model of space efficiency, or 0.7 percent annually based on a 10.6 billion-square-foot office-space inventory. Based on our analysis, it is our expectation the larger, more institutional submarkets, which represent about half of the overall office inventory, will continue to outperform at approximately 1.2 percent annual net absorption, with the smaller submarkets underperforming at approximately 0.2 percent annual net absorption.
As discussed briefly above, true new supply — new deliveries, as opposed to space shed back on the market through space efficiency — has been limited. We currently expect new deliveries equivalent to 0.7 percent of inventory per year. Subtracting new deliveries from overall net absorption, we arrive at our predicted annual availability reduction of 0.5 percent for the larger, more institutional submarkets. Lower vacancy rates may yield rent growth in the office market.
How current macro trends play out at the micro level
A belief that macro-level indicators could favor near-term appreciation of office property only gets us so far. National-level numbers and averages can be useful bellwethers of the overall climate but, at the same time, they are made up of unique individual properties in local markets with their own specific demand drivers. In addition, perceptions of different markets and market types influence capital flows in interesting ways that affect our thinking about investment.
The perception gap we find most interesting today is between technology-driven versus traditional office markets. In our view, tech-driven office markets, often in urban locations, have been much quicker than average to bounce back in terms of job growth, space absorption and office rent rates. The vast majority of new deliveries is limited to these markets, as well. Indeed, these markets are the exceptions to the broader dynamics playing out at the national level, as we discussed above. At an earlier phase of this cycle, there may have been good reason for capital to chase deals in these markets.
We believe, however, the strong performance of tech/urban markets over the relatively short term has resulted in a perception that traditional or suburban markets are untouchable. For years now, creative office, urban office, amenitized urban office and so forth, in our opinion, have been the darlings of office investors. Suburban office has been mostly ignored or avoided, leading in some instances to potential undervaluation of suburban product.
The reality of many traditional suburban office markets today is more nuanced, in our opinion, with differentiation between market-leading product and commodity product. Each investment must be evaluated on its own merits, but market-leading suburban product with potential for redevelopment and addition of urban-like amenities may be well-positioned.