The Office Sector Got Off to a Good Start in the First Quarter. But New Deliveries Are a Worry Article originally posted on National Real Estate Investor on May 9, 2019 U.S. office market performance in the first quarter of 2019 showed resilience, with roughly 14 million sq. ft. of absorption and dropping vacancy, despite increasingly cautious economic sentiment, reports real estate services firm JLL. Even with the delivery of 6.8 million sq. ft. of new office space to the market, vacancy dropped 30 basis points during the quarter to 13.0 percent, and asking rents rose 3.2 percent year-over-year, mostly due to expensive new space coming on-line, according to a Newmark Knight Frank’s first quarter 2019 National Office Report. But with 110.4 million sq. ft. of new space under construction, according to JLL’s office report, and a slowing marketplace, leasing activity is unlikely to keep up with new office supply delivered over the next couple of years. As a result, vacancy is expected to rise, especially for older office product, as some tenants move to new office space. Tenants are drawn to new office space because it tends to be more efficient, has bettercolumn spacing and windows that provide lots of natural light, as well as an amenity-rich environment, according to Scott Homa, director of U.S. office research with JLL. Office developers and owners are engaged in “an amenity arms race,” Homa adds, noting that office lobbies now have hospitality-style amenities and a range of activities to attract tenants, from state-of-the-art fitness centers to rock-climbing walls. Meanwhile, with new office construction at its highest point of the cycle, concessions are a material factor, as new office deliveries create softness in some markets, according to the JLL report. For example, some developers in the Washington, DC, area are offering more than $100 per sq. ft. in concessions, including up to 18 months of free rent on long-term leases, to lure tenants into their newest projects, according to Sandy Paul, senior managing director of national research with NKF. “Overall, new construction is less than 2 percent of total office inventory,” he adds, saying that this level of new product is considered manageable. Paul predicts, however, a surge in adaptive reuse of older product, noting that obsolete office buildings are already being repositioned as self-storage, seniors housing, apartments and even schools. The most challenging conversions involve unwalkable, suburban office parks, he notes. Nationally, as much as 1 billion sq. ft. of suburban office space may be obsolete. Co-working space led leasing activity in the first quarter, with 5.4 million sq. ft. of absorption, followed closely by technology firms, which took 5.3 million sq. ft., and finance and insurance firms leasing 4.8 million sq. ft. of office space. “It’s remarkable there is so much corporate demand for flexible space,” says Homa, noting that both medium and large companies are now using co-working space for mobile employees; when launching new or short-term projects, especially when the project size fluctuates; or for as a temporary staging ground for a project. “Typically, co-working space is an interim, stop-gap measure before entering a traditional lease,” Homa says, noting that average lease duration within a co-working space is usually under 24 months. Paul suggests, however, that the co-working boom may eventually level off, as its popularity is putting pressure on traditional office owners, who are increasingly establishing their own in-house flexible space programs to compete with co-working operators. Tenants’ desire for greater flexibility has led tp a downward trend in lease term for traditional space too. In the District of Columbia market, office lease terms have declined from an average of 7.03 years to about 6.85 years over the last three years. However, leasing velocity is accelerating, driven in part by corporate relocations, including Amazon’s HQ2. The company plans to eventually occupy at least 4 million sq. ft. in the newly named National Landing area of Arlington, Virginia. High absorption reflects the tight job market nationally and expansion of firms into mid-sized and small metros to access talent. “Predictably, smaller university towns and cities with good colleges and universities are seeing the most growth,” says Homa, noting that the most explosive growth is happening in Nashville, Tenn., Austin, Texas, Salt Lake City, Raleigh-Durham, N.C., Charlotte, N.C., Phoenix, and the Bay Area. “It’s s a chicken and egg scenario, as these cities are seeing a rise in statistical performance, but also are enabling growth of smaller industries and corporations facing a talent shortage.” A national employment report from brokerage firm Marcus & Millichap notes that 50 percent of new jobs created since 2016 are in secondary and tertiary markets with good colleges and universities. Commenting on this trend, John Chang, senior vice president of research services at Marcus & Millichap, says that companies used to bring talent to their headquarters, but are now opening satellite offices in places that already have a quality talent pool, like Orlando, Fla., Phoenix, Salt Lake City, Nashville, Charlotte and Las Vegas. Other advantages of these smaller markets include lower operating and cost-of-living expenses compared to primary markets, which often helps to offset part of the cost of relocation or expansion. For example, unlike competitive talent markets in the Bay Area and Los Angeles, Las Vegas, which is experiencing high population and employment growth, is a place that offers a low cost of doing business and living, along with access to a new talent pool. “Elements like this could transform the landscape and provide a trail ending in secondary cities,” Chang says. In addition, the new tax law structure, particularly capping of the deductible for state and local taxes, is beginning to drive companies to lower tax states, including Tennessee, Florida, Texas and the Carolinas, according to Chang. Relocation of the headquarters of Alliance-Bernstein, a major financial firm, from New York City to Nashville “may be indicative of what could become a broader trend,” says Homa. Expansion of firms into smaller metros is providing opportunities for real estate investors. While some are doing build-to-suit projects in these markets, others are focusing on value-add repositioning of existing space, driving down vacancies and lifting rents, according to the M&M report.