The Phoenix office sector has yet to find its footing as the adoption of hybrid work environments has upended traditional market dynamics. Companies are reevaluating their space needs, and many have opted to downsize their footprint or close offices altogether. This has led to a significant pullback in demand for office space with eight of the last 10 quarters recording negative net absorption. As a result, the metro-wide vacancy rate has been on a steady upward march, climbing from 11.4% in 19Q4 to 15.3% today.
Unlike the Egg Market, one positive factor for the market’s outlook is the lack of supply. Development has slowed considerably in the past 24 months and new construction starts are minimal. The amount of space under construction is at its lowest level since 2013, mitigating the risk of a further supply-driven imbalance. About 1.0 million SF of office space is currently underway, accounting for 0.5% of inventory, a fraction of the 1.6% seen at the national level. Anyone know where we can find one million hens??
Investment activity was steady in 2022 with $3.0 billion worth of office assets trading hands. The impact of rising interest rates became evident in the second half of the year as deal volume began to moderate. Moving forward, the wide bid-ask spread, elevated cost of capital, and macro headwinds facing the office sector will put upward pressure on cap rates and flatten price appreciation.
After recording flat absorption in the two years since the onset of the pandemic, the Phoenix office market further weakened in 2022. The recalibration of space configurations in the wake of hybrid work models is clearly having an impact. Tenants are targeting smaller footprints as their space needs evolve with the average lease signed over the past 12 months being roughly 10%-15% smaller than the average in 2017-19. Additionally, though aggregate leasing activity saw a modest increase in 2022, it remains 10% below pre COVID levels. As a result, new tenant demand was not enough to overcome several high-profile move-outs, contributing to -1.5 million SF of net absorption last year, the worst performance since 2009.
Demand is strongest in the Camelback Corridor and Scottsdale Airpark submarkets. These areas are more expensive but also offer an attractive mix of restaurants, bars, and other retailers while being situated close to population centers. Additionally, the tenant base is more heavily weighted toward law, healthcare, real estate, and finance firms, which has kept it more insulated from the surge in sublease activity seen in other parts of the Valley. These types of companies are generally more reliant on their physical footprints and have been less willing to give up space. Additionally, the first phases of new ultra-high-end office parks opened their doors recently and have been met with strong tenant demand. Healthy leasing activity at The Grove in Camelback Corridor and Cavasson in Scottsdale Airpark indicate that firms still value the physical office. Companies are willing to pay a premium to operate here in an effort to entice workers back to the office with an appealing office and amenity package in a desirable location.
Despite the protracted recovery in Phoenix’s office market, rents have rebounded more quickly than in many major metros and have held up remarkably well. Annual rent growth currently registers at 3.0%, compared to the national average of 1.1%.
However, rising sublease space availability is softening rent gains in several key submarkets. Downtown, Midtown, Tempe, and Chandler register weaker rent growth due to availability rates near 20%. In Downtown Phoenix, for example, sublet space can be found at a 40% discount compared to direct space in some instances and a 25% markdown can be found in Chandler. At the U.S. Bank Center located in the heart of Downtown Phoenix, sublet space is currently listed at $16/SF compared to $25/SF for direct space. In Chandler, Building B of The Park at SanTan has sublet space currently available at $28/SF full service vs. $38/SF full service for direct space.
Market wide, 1.0 million SF is under construction and typically about one-third of that space is available for lease. Construction is heaviest in Tempe and Deer Valley, high-demand submarkets with a large and high-quality talent pool.
Northern Tempe’s skyline is seeing additional growth as developers continue to build near the Tempe Town Lake/Salt River waterfront. One of the largest projects to finalize in 2022 was Mortenson’s The Beam on Farmer. Construction on the 184,000-SF speculative 4 Star office building started in 21Q2 after the project was delayed one year due to the pandemic. Space is currently being marketed for $44/SF full service. Nearby, construction is underway on the first building at Rio Yards, a speculative development comprising three 150,000-SF office buildings that are expected to finish in 2023. Anchored by the main ASU campus, this key corridor remains a construction hotspot and will see further development in the near future. Over 3.5 million SF of office space is currently under construction or proposed in the area 1 mile north and south of the river between the Loop 202 bend and Loop 101. It remains unclear to what extent proposed projects will move forward given the rapidly shifting office climate.
Investors continue to place capital in the Phoenix office market. Approximately $2.7 billion in office assets has traded here in the past 12 months, on pace with the five-year annual average of $2.9 billion. At $241/SF, pricing remains well below the national average of $340/SF. Despite the rise in vacancies, sublet space, and interest rates, cap rates have remained relatively stable at 7.1%, though early projections indicate they will likely rise in the coming year.
Chandler and Tempe are other submarkets that have received considerable interest, recording over $400 million in combined office investment dollar volume in the past year. These are employment centers with a strong talent pool and attractive amenity mix including bars, restaurants, and other retail. West Valley Properties, a regional real estate owner and developer, paid $53.1 million ($358/SF) for The Reserve at SanTan in September. The pair of offices were built near the Chandler Municipal Airport in 2020. The assets were about 90% leased at the time of sale.
Medical offices are also sought after, as the aging population generates heightened healthcare demand. The West Valley in particular has a concentration of medical office space to serve the retirement populations in Surprise and Sun City. For example, Heitman entered a JV partnership with Woodside Health to recapitalize a 12-property medical office portfolio in December 2022. The properties are predominantly concentrated across Surprise and Peoria. The deal totaled $114 million ($417/SF) and represented some of the largest medical office transactions of 2022.
Phoenix remains one of the nation’s best-performing markets for employment growth, recording more than 75,000 job additions in 2022. The labor market now has nearly 100,000 more jobs than before the pandemic, the fifth-highest gain in the nation. The local economy was highly resilient during the pandemic, thanks to a diversified employment base across a broad range of industries. Metro Phoenix lost about a quarter million jobs in March and April 2020 but by July 2021, Phoenix fully regained those losses, a stark contrast to its protracted recovery from the Great Recession.
An influx of residents and the market’s large educational institutions and colleges are significant contributors to the local talent pool. Metro Phoenix is home to the country’s largest public and private universities: Arizona State University (ASU) and Grand Canyon University (GCU). ASU enrollment surpassed 140,000 students in fall 2022, spread across five campuses and including online students. ASU’s primary location in Tempe is the largest, with more than 55,000 students on campus. Beyond producing new graduates, the universities collaborate with local employers on research and classroom curriculum.
Although the office market isn’t what it used to be prior to the pandemic, continuous growth in the valley shows promise to keep it above water. We have seen a steady desire for acquisitions in the office condo market and most do not stay available for long.
Want to expand your portfolio? Don’t put all your Eggs in one basket! If you have any questions regarding the office market or the economy, please do not hesitate to contact us.