Balancing Act: Lack of New Commercial Space Overcomes Softening Demand

Posted on April 12, 2012

Commercial real estate demand softened during the first quarter of 2012, but not enough to throw absorption off its pace of eight straight quarters of gains. The numbers were aided by little if any meaningful new construction coming online, resulting in declining vacancy rates.

Although rising energy prices and fiscal debt issues for both domestic and foreign governments remain as clouds on the horizon, the U.S. commercial real estate market remained firmly in recovery mode, led by the office and warehouse sectors, according to Walter Page, director of research for CoStar’s Property and Portfolio Research division.

CoStar’s national market research for the first quarter of 2012 showed that, while net absorption slowed slightly compared to the last half of 2011, rent trends generally improved from prior quarters, with the supply-demand balance supported by a lack of new space being added to the market.

“We may not be out of the woods just yet, but the data we’ve compiled for the first quarter certainly demonstrates an ongoing recovery and points towards future growth,” Page said. “While the retail recovery was less pronounced than in the office and warehouse sectors, we’re witnessing positive net absorption across the board.”

Office: Recovery Broadens

In the first quarter of 2012, office markets witnessed solid net absorption, with little new construction and near zero growth in asking rents.

“While the data shows near zero rent growth in the quarter, the national vacancy rate of 12.9%, combined with the prospect for future vacancy decline, suggests the scales are tipping toward generating office rent growth,” Page said.

Nationally, office net absorption was at 11.5 million square feet — down from 16 million square feet in the fourth quarter of 2011, but more than double the pace from the first quarter of last year. New construction deliveries were exceptionally low at just 5 million square feet, although construction activity is starting to rise with over 8 million square feet of new office starts in the quarter. Of the top markets, all but Washington, DC, achieved a year-over-year decline in vacancy, indicating the broad base for the office market recovery.

For the third quarter in a row, net absorption was very solid, with Houston and Chicago leading the nation at 1.6 million square feet each. Washington, DC, with negative 421,000 square feet of net absorption, recorded the lowest level among the top metros.

As a result, the national office vacancy rate dipped below 13% for the first time since 2008.

Industrial: Strong Absorption in Largest Markets

A sharp reduction in industrial vacancy, fueled by near zero net completions of space and positive net absorption, has supported steady to slightly rising asking rents.

In the first quarter, industrial vacancy fell to 9.4% nationally — down 0.7 percentage points from one year ago. The reduction in vacancy, which has supported a 1.5% annualized change in rent over the past quarter, was mainly driven by positive net absorption of 20.9 million square feet in the first quarter.

Of the largest U.S. warehouse markets, Chicago (2 million square feet), Los Angeles (1.8 million square feet), Inland Empire (1.8 million square feet) and Houston (1.2 million square feet) all exceeded 1 million square feet of net absorption. Together, these four metros accounted for a third of demand growth, which is 10% over the market share, as large box distribution markets continue to dominate new warehouse demand.

Indicating a broad-based recovery, nearly all top warehouse markets achieved occupancy gains compared to one year earlier, with the most significant being the Inland Empire’s 2.6%age point gain.

Retail Recovery Still Weak

While the retail recovery was less pronounced, the sector did achieve positive net absorption, a stable vacancy, and a near-stabilization of rent.

For the first quarter, vacancy nationally was unchanged at 7%, compared to 7.3% one year earlier. Net absorption of 9.4 million square feet was below the 16.2 million square feet of the fourth quarter. Retail completions were exceptionally low at just 4.3 million square feet, with a Salt Lake City urban retail project being one of the largest deliveries this quarter.

“We forecast completions of retail space to remain depressed for the year,” Page said. “In-process construction continues to fall compared to office and warehouse construction, which is rising slightly.”

At the metro level, retail performance was more of a mixed bag than other property types, with few standout markets. For example, market rent over the past year ranged in a narrow band with most markets showing a -5% to +2% change, as the impact of housing market distress and Internet retailing has curtailed demand growth. For the quarter, roughly one-third of the markets recorded negative net absorption, suggesting that the retail recovery is still weak. Market vacancy rates range from 2.8% in San Francisco to 12.1% in Phoenix.

By Mark Heschmeyer, Costar Group