The Phoenix office market has benefited from a matured, diversified economy. In previous quarters, office-using employment growth, fueled by major corporate expansions and relocations, stimulated demand for office space, particularly at the top of the market. Steady vacancy compression translated into some of the healthiest rent gains in the country in the past several years.
Robust employment growth and relatively limited new supply had supported the Phoenix office market. That was before the coronavirus. Efforts to help stop the spread of the virus has started to impact the local office market, both in terms of leasing and investment activity. A lot of the reports out there have been negative but as Franklin D. Roosevelt would say, “The only thing we have to fear…is fear itself.”
Phoenix has been a liquid office market benefiting from an expanding pool of buyers, though new deal flow has temporarily slowed due to rising uncertainties caused by the virus. Well-priced assets had generally traded within six months, and buyer appetite had put upward pressure on pricing. Steady cash flows, higher yields, a moderation in new supply were attracting new buyers.
Many investors who had previously written off Phoenix due to its boom and bust tendencies were taking a second look here since construction had slowed, and gradual leasing of shadow supply has helped compress vacancies below the market’s historical average.
Like many Tier II markets, Phoenix has garnered increased attention from investors, though the buyer profile is relatively unchanged; private and some institutional interest are driving the majority of transaction activity. National investors perceive Phoenix as still offering relative value. Cap rates have held stable, hovering near 7% over the past few years.
Leasing activity has temporarily slowed since the statewide stay-at-home order went into effect in late March. Still, a few deals have transpired. Amazon and Deloitte leased space at One Hundred Mill in Tempe, signing for 93,000 SF and 31,000 SF, respectively. The move is a new space for Amazon, while Deloitte will shift its 500 employees at its midtown Phoenix office to Tempe once the building is completed in late 2021.
Looking further ahead, negative absorption will persist through the remainder of 2020, according to the base case scenario. Amid weaker demand, construction, which was designated as an essential service, has continued. Vacancies will increase as new space is completed, with the rate expected to approach 14% by mid-2021. Once the effects of the virus fade, the demand drivers that worked in favor of Phoenix will continue to support the office market.
Healthy fundamentals had translated into steady rent gains that had consistently outpaced the National Index over the past several years. Before the virus, rent growth was already slowing from the highs of 2015–16. Annual rent growth fell from 4.9% at the end of 2019 to 2.9%, which is still above the market’s long-term average. Rent pressures will mount over the next several quarters due to the economic disruption and rising vacancies.
Phoenix’s relative affordability will continue to attract tenants looking to relocate or expand operations in the western part of the United States without paying sky high rents in coastal markets.
Development is on the rise in Phoenix following several years of relatively limited construction. Completions rebounded last year as roughly 2.7 million SF of office space came online, far above the pace of deliveries in the previous two years.
A few speculative buildings that delivered in the Chandler Submarket over the past few years have leased at a slower rate but are starting to fill. The 250,000-SF Chandler Viridian office development delivered in 19Q1 and had about 112,000 SF available for lease at the end of April. Nearby, 157,000 SF is vacant at Chandler Freeway Phase II, which completed in June. A few blocks south, Allred Park Place South delivered two buildings in 19Q2. Voya Financial committed to one of the 151,400 SF buildings and the lease began in April. The other 120,000 SF building is fully leased to Toyota Financial Services in December, and the tenant will occupy the space in August.
Phoenix has been a liquid office market benefiting from an expanding pool of buyers, though new deal flow has temporarily slowed due to rising uncertainties caused by the virus. Well-priced assets had generally traded within six months, and buyer appetite had put upward pressure on pricing.
The sale of the Grand I office complex in Tempe was one of the marquee transactions over the past year, achieving a high price per SF for the market. In December, Florida-based Susquehanna Holdings Company made its entry into the Phoenix market with the acquisition of The Grand I from the developer Lincoln Property group. The 4 Star office tower, located north of Tempe Town Lake, sold for $90 million ($411/SF). Built in 2017, the 219,200-SF office building is the first building in The Grand at Papago Park Center, a mixed-use development that will consist of 1.8 million SF of Class A office. The building was fully occupied at closing with Union Bank and SAP Industries. Susquehanna Holdings cited that “the fundamentals of the Tempe market meet all of the criteria we look for,” and the company expects the Phoenix economy to outperform most major Western U.S. markets over the next decade.
The Phoenix economy was on solid footing before efforts to contain the spread of the coronavirus wreaked havoc on the local economy. A pause in travel, a statewide stay-at-home order, and social-distancing had brought economic activity to a near standstill from mid-March to mid-May, when the stay-at-home order expired.
Unemployment claims have started to taper after reaching a peak of 134,000 claims in the week ending April 4th, but the amount remains far above pre-virus claims. The latest national jobs report in May shows signs that the country has started the path to recovery. Once the effects of the virus fade, the drivers that were stimulating tremendous growth in the Valley of the Sun will return.
While the number of companies expanding to metro Phoenix is noteworthy, the diversity of industries is necessary for sustaining the region’s long-term viability. More than a decade ago, Phoenix was synonymous with cheap labor and land that attracted call centers and back-office operators. Moreover, the economy was dependent on industries associated with household growth—construction, lending, brokerage, tile and cabinet manufacturers, etc. Because of the metro’s past reliance on housing, Phoenix was among the hardest-hit markets during the Great Recession; the market lost more than 300,000 jobs, 25% of which were in the construction industry alone. The market recovered from the Great Recession about two years after the U.S. The companies that Phoenix is attracting have evolved, and the market has emerged as a bustling technology and financial hub. FDR has said we, ourselves are essential to achieving victory. Our greatest primary task is to put people to work. This is no unsolvable problem if we face it wisely and courageously.
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