Sublease availability has jumped from an average of 2.1 million SF before the pandemic to 7.6 million SF, representing 3.9% of the total office inventory. These figures rank Phoenix as one of the most impacted markets in the country.

The investment market is feeling the impact of higher interest rates and tighter financing. Just $265 million worth of office assets traded hands in the second quarter, one of the weakest three-month periods in the past decade. A sizable gap exists among buyers, sellers, and the debt markets, which is stalling deal flow. Lenders are becoming increasingly conservative and hesitant, and many will require a compelling deal story or existing relationship to provide financing.

Despite persistently high vacancy rates, rent growth has remained in positive territory. Over the past 12 months,Phoenix office rents have climbed 4.1%, 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 lack of substantial construction activity is one positive trend helping avoid a further imbalance.Developers have slowed the pace of groundbreaking considerably over the past two years, leaving just 1.3 million SF of space underway, the lowest level in a decade. In fact, there are several offices being converted into other uses, including the Camelback One multifamily project at the former BMO tower in Midtown. The high-rise apartment complex has penthouse floor plans seeking over $8,000/month in rent.

LEASING

The Valley’s high-growth suburban areas are posting some of the strongest rent gains with rates in Glendale, Mesa, and Goodyear seeing strong growth. Meanwhile, higher-density sub markets closer to the metro core like Downtown, Midtown, and Northwest Phoenix are registering weaker rent growth. The surge in sublease space is also negatively impacting performance with office base sublet rents trending more than 15% below direct space, on average. The discount is even more dramatic in some sub markets like Downtown Phoenix, where sublet rents are nearly 25% lower. For example, in the U.S. Bank Center located in the heart of the CBD, full-service sublet space is currently listed at $16/SF compared to $25/SF for direct space for similarly sized footprints on the same floor.

The flight to quality office space could intensify rent growth for some of Phoenix’s marquee assets. When asked to make a bold prediction for 2023, one local office broker said he anticipates this year will see a major lease signing at $60/SF or more, a mark rarely hit outside of niche edge cases for very small blocks of space. The most recent high watermark was when Aon Service Corporation signed a seven-year lease to pay $57/SF full-service for a 3,700 SF block of space at The Grove, the Camelback Corridor’s newest luxury office development.

Office construction has decelerated over the past few years with just 940,000 SF of new office space delivered over the past 12 months, one of the lowest levels in nearly a decade. Construction starts have similarly eased as macro headwinds facing the sector and tighter lending standards reduce developer bullishness.

Market wide, 1.3 million SF is under construction, about a third of which is available for lease. Construction is heaviest in Tempe, particularly in the northern part of the sub market near the Tempe Town Lake waterfront, which is home to some of the Valley’s highest-end office space.

High-quality properties with strong tenants on long-term leases will still receive considerable attention. In February, Virtus Real Estate Capital, a Texas-based private equity firm, set a new price record for Valley office properties with its acquisition of a building at The Grove for $693/SF ($48.5 million). That price-per-square-foot figure is the highest in Phoenix’s history among properties larger than 5,000 SF. The single-tenant medical office asset was leased to Banner Health who moved into the property upon completion in early 2023 with commitments through 2033. The Camelback Corridor Sub market, where The Grove is located, is among the priciest and most sought-after areas for office investors, with market prices that average above $290/SF.

The above transaction was an outlier in many ways andthe bulk of trading is still done by private investorstargeting smaller properties, particularly if there’s someupside component. For example, a local privateindividual investor paid $4.55 million ($145/SF) for GroveParkway Court in April. Located in South Tempe, themulti-tenant property was 87.7% leased at the time ofsale to a broad mix of tenants in the financial services,medical, and technology fields. The transaction closed ata 7.13% cap rate with the ability to add value by drivingfurther occupancy.

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, Sun City, and Peoria. For example, Montecito Medical Real Estate purchased a three-story medical office property in March for $29 million ($395/SF). Located in Sun City, the 1980s vintage asset was fully leased to Banner Health at the time of sale, who was also the prior owner.