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How Will Offices Fare in 2020?

Feb 14, 2020 by Matthew DiLallo
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The fourth quarter was another lackluster one for the U.S. office market, according to the latest analysis by Moody's (NYSE: MCO) property analytics arm REIS. While the vacancy rate remained steady and rents continued rising during the period, the office property market is in a relatively tepid state.

However, while the overall picture for office property investors isn't very enticing, there are pockets of strength. Here's a closer look at the market data last quarter and what it means for commercial real estate investors who focus on office properties.

The building boom continues

The national vacancy rate of office real estate remained steady during the fourth quarter at 16.8%. On the one hand, that's good news since vacancies had been on the rise since bottoming out in the low 16% range in 2017. It's also a positive considering the amount of new space developers brought online during the period.

Overall, developers completed 13.7 million square feet (sf) of new office space in the quarter, 13 million of which the market absorbed with tenant move-ins. That was the highest level of net absorption since 2007. Meanwhile, the sf added during the period was just short of the 14.7 million sf developers brought online at the end of 2018, which was the highest level of construction and deliveries since 2009.

That uptick in new rentable space is one of several headwinds impacting occupancy, which also included economic and demographic changes, the continuous rise of remote working, and a shift in how office tenants use space. These factors have weighed on the growth of asking rent (i.e., the list price), which only increased by 0.6% during the quarter and 2.5% for the full year. While that matched 2018's rise, it was well below 2015's peak of 3.4% rent growth.

Hot spots in a cool market

While the overall U.S. property market was lukewarm last year, some markets stood out from the pack. Several metros, for example, saw notable declines in their vacancy rates during the fourth quarter, led by New Haven, Suburban Maryland, Tampa-St. Petersburg, San Bernardino/Riverside, and Columbus. Meanwhile, more than a dozen markets enjoyed asking rent growth of more than 1% last quarter, led by Seattle, Austin, Denver, Phoenix, and Raleigh-Durham.

For the full year, the following six metros delivered asking rent growth of more than 4%:

Office Market 2019 Asking Rent Growth Fourth-Quarter Vacancy Rate
Seattle 5.7% 10.7%
Austin 4.7% 13.0%
Denver 4.5% 16.9%
Charlotte 4.3% 15.7%
Tampa-St. Petersburg 4.1% 16.1%
San Francisco 4.1% 8.8%
National Average 2.5% 16.8%

Data source: REIS

Many of those markets enjoyed above-average office employment growth last year, which, when combined with lower vacancy rates, helped drive strong rent growth.

A quick peek at what's ahead for the office market in 2020

REIS also provided a brief outlook for what to expect in the U.S. office market in the coming year. The analytical group noted that forecasters expect the U.S. economy to expand by around 2% this year. While that's slower than last year's 2.9% increase, the risk of a recession seems to have faded, which is positive given the initial concerns that one would occur this year. Still, with the U.S. economy slowing a bit, it suggests that there won't be much improvement in vacancies nor an acceleration in office rent growth this year.

Meanwhile, a potential issue that office investors should monitor is the developments surrounding WeWork. REIS noted that the coworking company overexpanded and might need to reconsider some of its office leases. If that happens, it could cause vacancies in some markets to rise next year, which would likely weigh on rent growth.

Focus on the pockets of strength

Office property developers have added a significant amount of new supply in recent years, which has pushed up the country's vacancy rate and weighed on rent growth. However, while the overall market remains sluggish, several metros are delivering above-average rental growth, which is benefitting property owners in those areas.

Because of that, commercial real estate investors need to look closely at the fundamentals of a potential investment opportunity's market before they commit capital. That's because stronger metros will likely continue outperforming weaker ones in 2020, given the overall lackluster state of the U.S. office market.

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Matthew DiLallo owns shares of Moody's. The Motley Fool owns shares of and recommends Moody's. The Motley Fool has a disclosure policy.