May 2023 Office Market Report – Don’t Have a Cow, Man!
Office vacancies continue to remain higher than pre-pandemic levels as many companies have downsized their office space while many of their employees are now working from home. While a recent up-tick in demand for office space has occurred, we have yet to reach the levels that once were in place thus leaving many feeling like they’ve walked into a ghost town when entering the office. Cowabunga!
The Phoenix office market faces considerable uncertainty, as shifting preferences regarding workplace arrangements and a potential economic disruption stifle demand for office space. Against this backdrop, firms are reevaluating their space needs, and many have opted to downsize their footprints or shutter offices altogether. These factors contributed to -1.4 million SF of negative net absorption over the past 12 months, as nine of the past 11 quarters saw more space vacated than occupied. As a result, the metro-wide vacancy rate has steadily risen from 11.4% entering the pandemic to 15.4% today, with expectations for future increases in the coming quarters. Good Grief!
Submarkets like the Camelback Corridor and Scottsdale Airpark have held up better. These areas have a tenant base more heavily weighted toward law, healthcare, real estate, and finance firms, which are more reliant on their physical footprints and have been less willing to relinquish space.
Despite persistently high vacancy rates, rent growth has remained in positive territory. Over the past 12 months, Phoenix office rents have climbed 3.2%, outpacing the national level of 0.9%. One leading local office landlord rep indicated that concessions of about six months of free rent for a five-year lease term are typical.
The metro-wide vacancy rate has climbed from 11.4% in 19Q4 to 15.4% today, and the current outlook includes additional upward movement over the near term. The availability rate, which includes available sublease inventory as well as space that is on the market but has yet to be vacated, is often a better metric to track during periods of rapid change. The glut of sublease space continues to weigh on the market, particularly for modern properties that were leased to expanding technology and insurance firms. The availability rate for 4 & 5 Star properties have surged from about 15% in 19Q4 to 26.8% as tenants choose to relinquish large footprints in high end offices in the East Valley.
Demand is strongest in the Camelback Corridor and Scottsdale Airpark sub-markets. 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.
Despite facing near-term headwinds, rents in the Phoenix office market are holding up relatively well. Even during the depths of the pandemic, Phoenix office rent growth never turned negative, continuously outpacing gains seen at the national level. Over the past 12 months, rents have increased 3.5%, compared to 0.9% for the United States. Although underlying office demand has undoubtedly shifted, many property owners have been less willing to lower rents in an attempt to preserve investment value, and instead have opted for increased concessions or higher TI allowances. Concessions of six months of free rent for a five-year lease term are common.
Despite rents that are 10% higher today than in 19Q4, Phoenix maintains its position as a lower-cost office market. At $30.00/SF, the average office rent in Phoenix is roughly 15% less than the National Index of $35.00/SF, and the discount relative to West Coast markets is even larger with average rents in San Francisco and San Jose more than double that in Phoenix. Phoenix’s relative affordability will likely continue to attract tenants looking to relocate or expand operations in the western part of the United States without paying exorbitant rents in coastal markets.
The bulk of deliveries so far this year were for medicaloffice properties. In January, RED Development finalizedthe construction of a 70,000-SF facility for a new BannerHealth Center plus. The single-tenant medical officebuilding is the latest addition to The Grove, an ultra–luxurymixed-use development in the highly sought-afterCamelback Corridor Submarket. Builders completed workon the other office component in late 2022. The 181,500-SF office received considerable leasing demand signingSendoso, Clayco, and JLL, among others, on as tenants.
Office development is also heating up in the West Valley.Last year, builders finished work on the first phase ofGSQ, a large mixed-use project that Globe Corporationis conducting in partnership with the City of Goodyear. Itincludes Gen 1 at GSQ, a 104,000-SF office, as well asa new 125,000-SF city hall for Goodyear. Upon fullbuild-out, GSQ will include a two-story library and a 2-acre community park as well as space for restaurants,retail, and entertainment. About half a mile away,construction is progressing on a new 25,800-SF officefor Faith, Ledyard, & Faith (FLF), a West Valley-basedlaw firm. The partners of the law office are developingthe project themselves and will occupy half of the topfloor with the rest of the property available for lease.Speculative office development is very limited in theWest Valley, and the space will provide tenants with newoptions in the region.
The rise in interest rates, vacancies, and sublet space is continuing to weigh on transaction activity as buyer-seller pricing expectations remain at odds. Approximately $131 million in office assets traded in 23Q1, one of the weakest opening quarters of sales volume in nearly a decade. Higher capital costs and weaker projections for future performance gains have put upward pressure on cap rates, weakening property values. Moving forward, elevated interest rates together with broader economic uncertainty are expected to keep deal flow slow in the coming year.
CoStar is currently tracking more than $800 million in CBMS loan maturities coming due for Phoenix office assets over the next three years. Lower-quality properties with higher vacancies could face challenges when these loans mature, raising questions about default risk. While some investors have been anticipating an increase in distressed sales activity, the trend has yet to meaningfully materialize. CMBS office delinquencies remain low nationally and it remains unclear to what extent these deals will come to market.
Phoenix remains one of the nation’s best-performing markets for employment growth recording more than 70,000 job additions in 2022. The labor market now has 141,600 more jobs than before the pandemic, the third-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 positions in March and April 2020 but by July 2021, Phoenix fully regained those losses, which was about a year ahead of the U.S. This marks a stark contrast to its protracted recovery from the global financial crisis, when Phoenix didn’t recoup its job losses until well after the broader nation did.
The number of companies moving to metro Phoenix is noteworthy, but the diversity of industries has helped sustain the region’s long-term stability. Phoenix was synonymous with cheap labor and land that attracted call centers and back-office operators more than a decade ago. The economy depended on industries associated with household growth — construction, lending, brokerage, tile and cabinet manufacturers, etc. Because of its past reliance on housing, Phoenix was among the hardest-hit metros during the Great Recession; the market lost more than 240,000 jobs, 25% of which were in the construction industry alone. Phoenix 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 hub for advanced manufacturing, aerospace, life sciences, logistics,technology, and finance.
If you’re thinking about placing your office building on the market, either to sell or lease, we’d love to help. If you have questions about the office market or the economy, please feel free to reach out.