August 31, 2016
Months of agitation in the financial markets, driven largely by the slowdown in China, oil pricing and, most recently, Brexit, continued through mid-year, but is showing signs of calming. While turmoil has impacted deal flow in 2016 and uncertainty remains around the upcoming U.S. election, real estate capital markets are starting to normalize after atypically high volumes in 2015. Here are six themes from the U.S. office market so far this year.
Leasing Activity Rebounds
Having dropped by 17.3 percent in the first quarter, total quarterly leasing activity rebounded by 18.2 percent during the second quarter, quelling concerns the first quarter was the start of a broader slowdown. Coming in at 59.1 million square feet, 38.4 percent of total leasing volume was driven by primary markets. In addition to a rebound in leasing volumes overall, expansionary leasing activity for leases of 20,000 square feet or larger regained the lead as the majority driver of activity, comprising 46.3 percent of signed leases. While this is lower than the 48.4 percent average recorded over the past two years, it remains a good barometer for tenant sentiment toward expansion.
Occupancy growth keeping vacancy and new supply in sync, for now.
Overall, U.S. vacancy declined by 10 basis points during the second quarter, reaching 14.6 percent. Despite Houston’s best efforts, U.S. office sublease vacancy remained flat at just 1.0 percent of total inventory. The remainder of this cycle will be marked by ups and downs with new vacancies, net absorption and deliveries moving in and out of sync across markets – most notably, those with the largest development pipelines. Despite the mismatch of timing, risks of oversupply remain muted outside of Houston and U.S. sublease vacancy has yet to show signs of increase.
U.S. office volumes reforecasted to decline 10 to 15 percent in 2016.
Following six consecutive years of volume gains, office investment sale volumes decreased in the first half of 2016 by 6.4 percent, though this was from the peak of the current cycle. Heightened macro market volatility, beginning in late 2015, has calmed and, in the months post referendum, financial markets have shown signs of recovery, indicating a Brexit-induced recession is unlikely. One risk to inbound U.S. capital that remains is the increasing strength of the U.S. dollar. However, this continues to be countered by the lower perceived risk of the market relative to the U.K. and other global markets from both occupiers and investors. Looking forward, there remains a strong pipeline of large office portfolios exceeding $1.0 billion that could boost activity. Despite this strengthening, year-end transaction volumes are expected to decline between 10.0 and 15.0 percent, a function of declining single asset activity.
Despite declining activity, asset pricing resilient…but signs of plateauing are emerging.
Current pricing levels is evidence the U.S. office sector remains cautiously optimistic. Pricing remains steady and cap rates continue to compress despite declining activity. In fact, the pace of compression has increased over the past 12 months. This sharpening in pricing is being led by primary markets, with Washington, DC, Boston, Los Angeles and Seattle leading the way. Secondary markets, however, are beginning to tell a different story with select markets softening, a sign pricing levels may be plateauing.
Notable shift back to primary markets indicates investors’ avoidance of market risk.
After the continued expansion into secondary markets over the last two years, volumes are moving back toward primary markets. In the second quarter of 2016, 70.1 percent of total transaction volume took place in primary markets. This is especially the case for more institutional groups, leading to a cooling off of select secondary markets. As a result, the pricing spread between primary and secondary markets has widened. With a second wave of latter cycle office cap rate compression beginning in primary markets, both volume and pricing analytics are pointing toward investors’ resistance to market risk, spurring a more acute focus on market, submarket and even asset-level stability and resilience.
Pullback in risk also evident on submarket level as investment clustering increases.
Investors are adopting a heightened focus on lower risk submarkets amid market jitters and cycle longevity concerns. This is evident in both primary and secondary markets with activity clustered and thus liquidity strongest in leading CBD and core suburban submarkets. In primary markets, investment into three submarkets or less of a given market increased from 69.4 to 77.3 percent year-to-date. Secondary markets consistently have had a high concentration of activity in three submarkets or less – over 90.0 percent since 2013 – as a means of mitigating risk. Over the course of 2015 and 2016, all secondary markets have seen more than 50.0 percent of capital invested into three submarkets or less.
For more about the current environment for U.S. investment across the industrial, lodging, multifamily and retail sectors download JLL’s U.S. Investment Outlook.