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The North American, U.K. and German office sectors reported overall healthy leasing fundamentals at the mid-point of 2016. Despite positive absorption on both sides of the Canada-U.S. border, vacancy in Canada has risen, while the U.S. rate decreased year-over-year, bringing vacancy in the two countries into closer alignment than at any time since the Great Recession. The effects of depressed oil prices continue to be felt in certain U.S. and Canadian markets – a situation that may result in further volatility affecting local leasing metrics.
These are some of the key trends noted in Avison Young’s Mid-Year 2016 North America, U.K. and Germany Office Market Report.
The report covers the office markets in 61 Canadian, U.S., Mexican, U.K. and German metropolitan regions: Calgary, Edmonton, Halifax, Lethbridge, Montreal, Ottawa, Quebec City, Regina, Toronto, Vancouver, Waterloo Region, Winnipeg, Atlanta, Austin, Boston, Charleston, Charlotte, Chicago, Cleveland, Columbus, OH; Dallas, Denver, Detroit, Fairfield County, Fort Lauderdale, Greenville, Hartford, Houston, Indianapolis, Jacksonville, Las Vegas, Long Island, Los Angeles, Miami, Minneapolis, Nashville, New Jersey, New York, Oakland, Orange County, Orlando, Philadelphia, Phoenix, Pittsburgh, Raleigh-Durham, Reno, Sacramento, San Antonio, San Diego County, San Francisco, San Mateo, Tampa, Washington, DC; West Palm Beach, Mexico City, Coventry, London, U.K.; Duesseldorf, Frankfurt, Hamburg and Munich.
“Our annual mid-year review of the office sector has once again expanded along with Avison Young, and now covers 61 markets (up from 50 in 2015), including additional markets in the U.S. and the U.K., as well as Mexico and Germany for the first time,” comments Mark E. Rose, Chair and CEO of Avison Young.
Rose continues: “The divergence in economic performance between Canada and the U.S. that we reported in 2015 has continued during the intervening 12 months. As a result, office market fundamentals in the two countries have also posted differing results. While the U.S. shows continued signs of improvement, Canada has seen varied performance from its office markets. Rounding out North America, the Mexico City office market is performing well with a healthy vacancy rate – though vacancy is at its highest point since the end of 2013. Meanwhile, in Europe, the Brexit vote in June marked the start of a period of uncertainty for the U.K. economy and property market. Despite this uncertainty, and a reported low level of leasing activity, U.K. vacancy rates remain at historically low levels. And in Germany, the top office leasing markets recorded solid take-up levels on the back of a stable and growing economy with leasing activity above the long-term average across all markets.”
“The U.S. office market demonstrated further strengthening during the last four quarters. November’s presidential election should have little impact on commercial real estate after a year of generally positive economic growth reports – increased consumer spending and real gains in employment resulting in sub-5% unemployment levels. In addition, the Federal Reserve is unlikely to raise interest rates until late in the year. In Canada, softer economic results were reflected in the office market’s performance. Not surprisingly, this situation was mostly attributed to weak market fundamentals in Alberta, while Toronto, Montreal and Vancouver saw an uptick in demand. Nevertheless, we expect continued deal velocity for the remainder of the year in Canada, while vacancy could face upward pressure and rents could experience downward pressure due to new supply and moderate demand,” says Rose.
According to the report, of the 61 office markets tracked by Avison Young in North America, the U.K. and Germany, market-wide vacancy rates decreased by varying degrees in 34 of the markets on an annualized basis. Given that all five countries reported positive net absorption over the 12-month period, the fact that only 56% of markets saw decreasing vacancy demonstrates the importance of understanding individual markets’ demand drivers, construction pipelines and local economic conditions.
With the exception of Canada, the amount of space under construction ticked upward in most markets year-over-year, and preleasing levels are significant. Nonetheless, stakeholders will need to monitor vacancy levels on a market-specific basis for signs of oversupply.
With the national economy stuck in neutral amid less-than-stellar GDP and employment numbers, Canada’s stable office leasing fundamentals are increasingly coming under pressure. The 12 office markets surveyed posted varied results in most major metrics – vacancy, rent, absorption and development – for the 12 months ending June 30, 2016. In addition to the effects of a battered commodities sector, the acceleration of new supply is causing some markets undue stress, offsetting meaningful demand while pushing vacancy upward and rents downward.
“I don’t think we expected anything dramatically different from what has transpired in Canada’s office markets during the past year and, particularly, in the first half of 2016,” states Bill Argeropoulos, Principal and Practice Leader, Research (Canada) for Avison Young. “While Calgary’s challenges have been well-publicized, the city is no stranger to wild vacancy swings and prolonged recovery cycles. It’s not all doom and gloom for the Canadian office sector, though. Despite construction levels similar to those in Calgary, Toronto has surprised many observers with the resilience of its performance. This resilience is most visible in the downtown market – which some had argued was being over-built – due to the successful lease-up of new developments and dwindling vacant backfill space.”
Argeropoulos adds: “Fundamentals will be tested as the bulk of new supply makes its way through the system in the next 18 to 24 months, holding back any significant rental rate growth. A tenants’ market will likely ensue in commodity-, development- and vacancy-laden markets. Looking forward, the millennials’ impact in years to come may be more profound than simply altering the way we plan our working environment. As more organizations densify their premises, putting more workers into less space, there may be a measurable effect resulting in long-term absorption levels below historical averages.”
Notable Mid-Year 2016 Canadian Office Market Highlights:
· Despite uneven demand in local markets, Canada registered positive 12-month absorption of almost 1.9 million square feet (msf) between mid-year 2015 and mid-year 2016. Toronto, Montreal and Vancouver had strong showings, while the East widely outperformed the West.
· Year-over-year, Canada’s office vacancy climbed 170 basis points (bps) to 12.1%, rising in 11 of 12 markets – due to weak fundamentals, notably in Calgary and, to a lesser extent, in Edmonton. Calgary had the highest vacancy rate and biggest change (+820 bps), while Winnipeg (6.8%) had the lowest.
· Varying demand and construction levels highlighted the gap between downtown and suburban markets and from city to city. Weighed down by Calgary and Edmonton, the Western markets’ vacancy spiked 390 bps year-over-year to 14.2% at mid-year 2016. Eastern markets experienced a modest 60-bps bump to 11%.
· Driven by urban intensification, downtown markets registered robust 12-month absorption of 1.4 msf. However, new supply of more than 3.7 msf in the same period lifted downtown vacancy to 10.6% (+170 bps) nationally. While steady in the East (8.2%), downtown vacancy rose considerably in the West (14.5%, +470 bps).
· Following more than 4.2 msf of office completions, suburban markets recorded modest year-over-year growth, driving vacancy up to 14.1% (+200 bps) at mid-year 2016. Led by Calgary and Vancouver, the West outperformed the East in suburban office completions.
· Canada added more than 8 msf of new office supply from mid-year 2015 to mid-year 2016 with suburban markets slightly leading their downtown counterparts. More than half of the new inventory was added in Toronto and Calgary.
· Developers are looking beyond near-term setbacks with more than 16 msf under construction (56% preleased) and downtown projects doubling suburban in terms of size. Calgary and Toronto lead with notable development also underway in Vancouver, Edmonton and Montreal.
· Elevated vacancy has kept rents at bay and fragmented among asset classes. Average class A asking rents dipped in both downtown ($21.61 per square foot (psf), -$1.75 psf) and suburban markets ($17.69 psf, -$0.13 psf).
In contrast to office market conditions in Canada, according to the report, the office sector in the U.S. experienced broad-based improvement. Vacancy in the 4.6-billion-square-foot (bsf) U.S. office market tracked by Avison Young tightened at mid-year 2016 when compared with the vacancy recorded a year earlier. For the office markets, common themes persisted during the 12-month period ending at mid-year 2016 as occupiers again focused on space efficiencies and a preference for locations served by public transit and walkable conveniences.
“Absorption in the U.S. office sector was a notable indicator of the markets’ increasing health as the country posted 43 msf of net absorption between mid-year 2015 and mid-year 2016,” notes Earl Webb, Avison Young’s President, U.S. Operations. “During the same period, class A rental rates in downtown markets spiked, moving almost 8% higher. With another year of sustained job growth, the overall U.S. unemployment rate fell below 5% in 2016. We anticipate that favorable leasing fundamentals for the office sector will be ongoing through year-end 2016, and although select markets may experience some delay in office lease executions until after the election is decided, this situation should have minimal impact on market conditions into 2017.”
Webb continues: “Development is on the rise in answer to demand for new buildings, while the growing presence of amenity-rich, co-working options may spur owners of older properties to add social gathering places and tenant-recreation areas to compete for occupiers in this environment.
Notable Mid-Year 2016 U.S. Office Market Highlights:
· National office vacancy dipped to an average of 12.7% at mid-year 2016 – a 40-bps improvement compared with the same period one year prior. Downtown markets experienced less change (down 20 bps from mid-year 2015), but have tighter conditions overall with 10.8% vacancy inclusive of sublet space and 15 markets reporting vacancy in the single digits.
· The cluster of Northern California downtown markets – San Francisco, Oakland and San Mateo – reported extremely low vacancies of 5.5%, 3.9% and 1.7%, respectively. In New York, the nation’s largest downtown market with 443 msf, vacancy improved by 40 bps falling to single digits (9.6% vacant).
· Twelve-month net absorption in the U.S. was 43 msf for the period ending June 30, 2016, representing nearly a 16% decline year-over-year and only 0.9% of existing inventory. Suburban markets captured the bulk of net absorption achieved between mid-year 2015 and mid-year 2016.
· The U.S. had 90 msf of office space under construction at mid-year 2016, up from 82 msf one year earlier. Projects under construction are 50% preleased, pointing to the demand for new buildings.
· Three U.S. markets have significant volumes of construction activity. New York has the greatest amount by far (15.1 msf, 46% preleased), followed by Washington, DC (11.1 msf, 31% preleased) and Dallas (10.2 msf, 67% preleased). These three markets alone accounted for 40.3% of all U.S. development underway at mid-year 2016.
· Houston delivered 7.9 msf between mid-year 2015 and mid-year 2016 and has another 3.8 msf under construction; however, 3.8 msf is a modest volume, as Houston reported an average of 11.7 msf under construction at mid-year 2013, 2014 and 2015.
· Pricing again trended upward and average asking class A rental rates grew in both downtown and suburban markets with downtown rents increasing significantly by $3.69 psf, or 7.7%, year-over-year to $51.80 psf. Notably, of the 39 downtown markets tracked, all but five reported increases in their rental rates.
“In 2015 we reported a return to more balanced leasing conditions with lower vacancy after several years of absorption and job growth, and the office market remains the strongest we’ve seen since the Great Recession,” adds Webb. “Companies have demonstrated a distinct preference for work-live-play environments with a mature infrastructure of tenant services to aid their recruiting efforts. For the remainder of 2016, tenants’ need for space efficiencies and flexibility will endure. Nevertheless, we expect this year’s office leasing levels to be in line with historical averages and, in spite of elevated volumes of construction, no real threat of oversupply.”