Q2 2012 Phoenix, Arizona Office Market Trends

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Q2 2012 Phoenix, Arizona Office Market Trends

A spark, not a fire. With the local and national economies churning out positive job growth, thin shafts of light have become visible in the gloomy Phoenix area office market. Demand inched ahead of new supply last year. And with no construction delivering year-to-date in 2012, moderate positive net absorption, the theme through the first two quarters, applied additional tightening. These small improvements, however, are dwarfed by an extraordinarily high vacancy factor, an effect of the severe economic downturn and, at the time, ongoing additions of new supply. Rents to date, accordingly, have been unable to manifest a decisive return to growth. And construction, while increasing at the margins with a few recent starts and a few new plans, mainly in the East Valley, remains muted. Recovery, while generally expected, may run slow for a while.

OCCUPANCY


Not since 1990, when the volume of vacant stock was considerably smaller, did the Phoenix area office market see a vacancy rate higher than the 26.6% reported for first quarter 2011, the peak rate of the latest cycle. The 18.6 million square feet thus represented was unprecedented. With absorption running positive through recent quarters, a gradual downward trend has emerged. The rate for the second quarter of 2012 was 25.9% (representing 18.3 million square feet), down 10 basis points from quarter before, down 60 year-over-year. Meanwhile, construction has ceased. With no new standard competitive space expected to deliver all told in 2012, additional improvement is likely for occupancy. Still, Reis expects the vacancy rate to remain above 20.0% into 2015. Sublease space, meanwhile, accounts for 11.0% of total vacancy (about 2 million square feet), same as the national rate.

With Class A projects dominating recent construction and Class A landlords driven by high vacancy to offer concessions on rents, “flight to quality” has been a recent factor. At 27.5%, second quarter Class A vacancy was down 100 basis points year-over-year. The second quarter 23.9% Class B/C rate was down only 20 points over the same span. “Landlords,” notes Jones Lang LaSalle in a second quarter report on the local market, “are still seeking a number of tenants in the market seeking to make that flight.”

SUPPLY AND DEMAND


Digging out. The harsh realities of the latest recession produced a demand to supply deficit on the order of 11.7 million square feet over the three-year span 2008-2010 as the completion of 4.6 million square feet of new space was met by net absorption at negative 7 million. With construction brought to a near halt and absorption back on positive ground, the market is slowly digging itself out from that deep hole.

While net absorption ran in excess of same-year new supply by only 132,000 square feet all told last year, the recovery trend nonetheless finally was underway. The lack of new space deliveries during the first half of 2012, then, was accompanied by net absorption at 161,000 square feet representing additional, slightly larger steps. With activity expected to accelerate, a year-end total of about 500,000 square feet is anticipated along with no additions to supply. In what seems to reflect the “flight to quality” cited as a current factor, net absorption of Class A space during the first half of the year was counted at 183,000 square feet while the year-to-date Class B/C total was negative 22,000. “With the latest round of construction far behind us and with the market beginning to show signs of turning,” comments Jones Lang LaSalle, “landlords are poised for what will likely be home to some of the strongest demand for office space in

the country.” Despite the high overall vacancy, meanwhile, larger users (100,000 square feet or greater) “are experiencing tighter market conditions and fewer choices,” notes Jones Lang LaSalle. This has resulted in a growing urgency in that renter cohort, which could impact absorption in the period ahead.

Construction, meanwhile, remains quiet. Three projects with a combined total of 342,200 square feet broke ground in 2012 to date (none others are expected). One is an 114,100-square-foot single-tenant building. The others are competitive buildings in local office parks. “No significant office projects are currently planned to break ground during the balance of 2012,” notes Jones Lang LaSalle. Indeed, none on Reis’ list of general purpose projects has been assigned a start date. Still, notes Cushman & Wakefield in a second quarter report, “Phoenix is poised for sustained growth that will prompt speculative construction.” By 2014, Reis expects annual completions will have returned to the 1-million-square-foot-plus level, familiar territory for this market.

RENTS


The year 2011 was the fourth in a row to see overall losses in average asking and effective lease rates even as stabilization emerged in the course of the year. Given the high vacancy and competitive environment, however, only small increases have followed year-to-date in 2012. At $22.30 psf and $17.32 psf, mean asking and effective rates for second quarter were up 0.4% and 0.3% since year-end (growth at 0.0% is indicated for both rates for second quarter alone). Increases slightly above 1.0% are forecast for both rates for the year.

“Landlords,” observes Jones Lang LaSalle, “continue to offer generous concession packages, along with very competitive rental rates” in hopes of generating tenant flight to quality. Notes Cushman & Wakefield, “Several large lease signings drew considerable concessions indicating that enticements for tenants are still required in the market.” See Special Real Estate Factors for additional commentary on landlord concessions.