Have you been working from home? Have you gone back to the office yet? This past year has been full of changes within the office community and some days you may just feel like you are playing Conference Call Bingo while trying to juggle the day to day alongside the nuances of moving your office space from the well-established cubicle or desk within the comfort of your “designated” spot at work to that newly revised area in your home. Luckily, most of us have been able to rejoin the workforce back in our corporate offices while some may still be tinkering on the home front. Most are probably doing both. Either way, it is certain that the pandemic has affected office space in the commercial real estate industry but how long do we expect this to last? Will it ever come back to where it once was? Let’s take a look…
Uncertainties surrounding the spread of the virus have slowed new office investment activity. In previous quarters, investors were bullish on Phoenix, and the buyer pool expanded, with more out-of-state investors drawn to the market’s comparably higher yields. Increased buyer competition had put upward pressure on pricing, and office properties have only recently approached near the previous peak pricing.
A relative lack of new supply was also supporting metrics. Demand had outpaced new supply for nine consecutive years, and vacancies had returned to prerecession levels at the end of 2019. Steady vacancy compression translated into some of the healthiest rent gains in the country in the past several years. But construction starts edged up late last year, and the market is on pace to receive an increase in speculative supply over the next several quarters amid weaker demand, which will put upward pressure on vacancies.
Before the virus outbreak, major corporate expansions and relocations stimulated demand for top-tier office space. Demand had outpaced new supply for nine consecutive years, and vacancies had compressed from the 2011 peak of more than 20% to the rate of 12.5% which is healthy for the market, and below the long-term average, thanks to the moderation in development over the past decade.
Negative absorption will persist through the remainder of 2020, according to the Base Case scenario. Amid weaker demand, construction has continued nearly unscathed. Vacancies will increase as new space delivers, 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.
Rent pressures will mount over the next several quarters due to the economic disruption and rising vacancies. A rise in sublease availabilities will also put pressure on rents since these spaces are offered at a significant discount to direct marketed space.
Despite consistent rent appreciation, Phoenix maintains its position as an affordable office market. The average office rent in Phoenix is roughly 30% less than the National Index, and the discount relative to West Coast markets is even greater. San Francisco’s average rent is about two and a half times that in Phoenix, and Los Angeles’ is about 50% higher. 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.
Speculative projects that are slated to deliver over the next several quarters are expected to achieve slower lease-ups however, the pace of construction has continued nearly undisturbed by the pandemic. Almost 1.5 million SF delivered in the first half of the year. Among the completed projects are a few buildings in Tempe, such as The Watermark, IDEA, and Rio2100 offices and a built-to-suit for American Express in North Phoenix. In July, Ryan Companies completed the first of three office buildings within the Novus Innovation Corridor mixed-use development at Arizona State University. ASU preleased about 70,000 SF and took immediate occupancy in the 170,000-SF office building on University and Rural Road.
An additional 3.3 million SF of office space is underway, half of which is available for lease. Construction is concentrated in Tempe and Scottsdale Airpark, high-demand submarkets with a large and high-quality talent pool. About 2.8 million SF is slated to deliver by year end, and nearly 3 million SF will come on line next year.
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. Deals are still transacting since March, albeit at a much slower pace. Many investors and lenders have paused and are taking a wait and see approach. Many sales over the past several months stem from 1031 exchanges.
Thanks to the large labor pool, businesses are selecting Phoenix to expand their operations. While labor is the primary driver behind the market’s business attraction success, relative affordability helps tip the scale in favor of Phoenix when companies make their site selection decision.
An influx of residents and the presence of large educational institutions and colleges are growing the local talent pool. Metro Phoenix is home to the largest public and private universities in the country: Arizona State University (ASU) and Grand Canyon University (GCU). ASU enrollment surpassed 119,000 students in fall 2019, spread across five campuses, and including online students. ASU’s main campus in Tempe is the largest, with more than 53,000 students on campus. Beyond producing new graduates, these universities are also prominent employers in the metro and collaborate with local employers on research and classroom curriculum.
If you have any questions about the office market and where it might be headed or want to talk about any other commercial real estate investments, please feel free to contact me! You can even conference call me!