The pandemic has disrupted what was a consistently positive performance in the Phoenix office market. Employment growth and relatively limited new supply supported fundamentals over the past decade. But efforts to contain the virus’ spread have impacted the local office market, at least in the near term. While the office sector has been more resilient than the retail and hospitality property types, the cracks have appeared: leasing activity has slowed, sublease availabilities have risen, and transaction volume has tumbled. Admittedly, the degree to which the market will be affected and the length are unknown. The recovery will depend on how quickly the health situation improves, how comfortable people feel about returning to the office, and whether companies decide to rethink their space needs. The 2020 Phoenix office market looked like a scene from the movie Groundhog Day! It felt like we were stepping in the same puddle, day after day, but there is hope around the corner as the office market begins to shift.
“Whew! Watch out for that first step. It’s a doozy!”
Last year, move-ins were offset by firms giving back unused space as employees worked from home. At the same time, speculative office projects delivered throughout the valley, and vacancies edged upwards. Even at 12.8%, vacancies are below the long-term average. Despite the rise, the rate was low heading into 2020, thanks to the moderation in development over the past decade.
Opendoor had pre-pandemic plans to double its workforce, and its 100,810-SF lease began in 20Q2 at the Tempe Watermark. Before the lease commenced, the company filed a WARN (Worker Adjustment and Retraining Notification Act) notice for about 145 jobs. By September, Opendoor sublet 33,890 SF with rents of $39/SF, compared to a direct lease at $45/SF. Zip Recruiter has also rapidly expanded in Tempe, but the pandemic caused the company to trim about one-third of its personnel, with many of the cuts in the Phoenix market.
Net absorption will remain below the historical average over the next 12 months, according to the Base Case scenario. Vacancies will increase as new space delivers, with the rate expected to approach 13% by mid-2021.
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. Rent growth fell from 4.9% at the end of 2019 to 0.2%.
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.
The development pipeline has picked up over the past two years, following years of conservative new supply. From 2000-07, the market’s stock grew by an average of 6 million SF each year, but the annual level has moderated to about 2.3 million SF over the past five years. But last year, development ramped up in high-demand submarkets in the East Valley.
In 20Q1, Hines broke ground on 100 Mill Ave., a 5 Star office tower located in the heart of Downtown Tempe. The 287,000-SF high-rise is more than 40% leased to Amazon and Deloitte, well ahead of its scheduled delivery in 21Q4. The project has the highest asking rents in the market at $50/SF.
While some developers delayed starting construction on a few planned office projects due to the pandemic, work began on two speculative developments in the second half of 2020. In 20Q2, DPC Development broke ground on the Scottsdale Entrada in South Scottsdale. The spec development is located at a vacant lot in an Opportunity Zone and will include 245,000 SF of office, apartments, and retail space.
National investors perceive Phoenix as still offering relative value. Cap rates have held stable, hovering near 7% over the past few years. Phoenix cap rates are 150-200 basis points above California markets. As a result, California-based buyers looking for higher returns are bolstering sales volume and account for nearly one-quarter of deals over the past year. In one of the larger office deals over the past few months, California-based Stockdale Capital Partners acquired a 371,940-SF medical laboratory and creative office building in the Scottsdale Airpark for $65 million ($175/SF). The purpose-built property served as Henkel’s North American headquarters, but the company recently relocated its operations back to Connecticut, leaving the building 17% occupied at the time of sale. Stockdale will invest millions in rebranding and cosmetic upgrades to help entice technology and life-science users.
The 82 office deals last quarter traded at an average price per SF of $181, somewhat below CoStar’s estimate of the average price across all assets in the market ($205/SF). Based on the property-level estimates, pricing in Phoenix increased 3% over the past year. Pricing has just recently approached the previous high. Most trades happen in the $120/SF-$200/SF price range, but a meaningful percentage of deals have traded above $320/SF.
The sharp job losses caused by the pandemic were temporary, and Phoenix bounced back quicker than most other metro areas. Phoenix lost about 200,000 jobs in April and March. By November, the market recovered about 80% of those job losses as businesses reopened and school began. Phoenix is still on the road to recovery. The recovery depends on an improving health situation, and the baseline forecast anticipates that employment will return to pre-pandemic levels by mid-2022.
The competitive advantage and growth drivers that were stimulating growth in the Valley of the Sun may be stronger than ever. People living in dense and expensive cities have always looked to Phoenix for job opportunities and affordable living. But a rise in remote work will entice more people to move to Phoenix as an affordable option to California or East Coast markets. The market is better positioned than it was a decade ago. Once known for cheap labor and land and identified as a retirement community, Phoenix has become a dynamic and vibrant market. Population growth, a diversifying economy, relative affordability, and business-friendly regulation have strengthened the Phoenix value proposition. These characteristics are attracting more than 200 people to Phoenix each day.
The office market has obviously been affected by the pandemic, but a positive outlook may be on the horizon as thing slowly return to normal. While some may still be working from home, many have returned to their offices and, as the vaccine becomes more available and the virus number decline, we may begin to see more and more returning to life as it once was prior to the pandemic. If you have any questions regarding the office market and where it might be headed, please contact me. I am happy to help!