Investors are moving up the risk curve and the share of cross-border investors is growing, writes Andrea Cross

The US economic recovery gained steam in the first half of 2013, adding more than 1.2m jobs. The accelerated rate of job growth underscores the resilience of the recovery despite sequestration in the US and economic slowdowns in many other countries. As of June 2013, the economy has recovered about 75% of jobs lost during the recession. As the effects of the sequester dissipate into next year, the economic recovery should gain steam, resulting in stronger GDP and employment growth. Total employment is on track to reach the recent peak of about 138.1m jobs by the middle of 2014.

The recovery is now broadening to include more markets and employment sectors, a trend reflected in Q2 office data. The housing recovery has been a key component of this, due to increased sales and construction having boosted payrolls in related sectors, and in some of the hardest-hit markets during the recession. The National Association of Home Builders/Wells Fargo Housing Market Index (HMI) exceeded 50 in June 2013 for the first time in more than seven years, and jumped to 57 in July, even amid rising mortgage rates.
Despite recent increases in new home sales and construction, the housing market recovery still has significant room to run; single-family housing starts totalled a seasonally-adjusted annual rate (SAAR) of 591,000 in June 2013, only slightly more than half the average SAAR during the last 30 years.

Housing completions (both single-family and multifamily) totalled a SAAR of just 755,000 in July, well below IHS Global Insight’s projection of 1.4m new housing units (both single-family and multifamily) required annually to accommodate current growth in the number of primary households, demand from second-home buyers, and demolitions.

Positive trends were recorded in Q2, with the North American vacancy rate decreasing by 10bps to 13.86% from the previous quarter. The US vacancy rate decreased by 14bps during the period but remained nearly double the Canadian vacancy rate, which increased by 33bps during the quarter to a still-low 7.24%.

Colliers International tracked 56 North American markets with registered quarterly decreases in vacancy rate over the quarter, 30 markets with registered increases and one market that was unchanged.

Absorption accelerated during the second quarter, bringing the year-to-date total to 19.4m sqft. Among the markets tracked by Colliers International, 63 posted positive absorption during the first half of the year, and 24 posted negative absorption, including six of the 12 Canadian markets. ICEE markets continued to lead, including Boston, San Jose, Orange County, San Francisco and Denver.

However, it is noteworthy that several markets that have been lagging during the recovery were among the top markets for net absorption through the first six months of the year, including Orange County, Atlanta and Chicago.

Another notable trend is that technology and energy companies, unable to find employees with the desired skills in the typical hubs for their industries, are relocating to or expanding into other metropolitan areas. This should result in a broader recovery in office market conditions.

A less obvious benefit of the onshoring of manufacturing activities is its positive impact on office demand. Today’s increasingly automated and efficient supply chain requires a skilled workforce to handle highly complex engineering, design and production functions.
Firms often prefer to locate these workers near production facilities to facilitate communication and improve efficiency. Thus, we expect growth in office demand near returning and expanding manufacturing facilities to accommodate their white-collar employees. Markets in low-cost, right-to-work states such as Phoenix, Houston and Dallas will most likely be the primary beneficiaries of this trend.

Proximity to educational institutions that provide the skilled workforce to handle these complex functions is also critical. Thus, markets such as Raleigh-Durham and Atlanta, which combine a high concentration of top-tier research universities and a relatively low cost of doing business, are well positioned to accommodate additional growth in office demand from manufacturing.

According to Dodge Pipeline data, US office construction activity totalled 75m sqft as of mid-year 2013, with 27% of this space composed of medical office properties.  

Construction taking off
Construction remains highly concentrated in markets with the strongest economic growth and tenant demand in recent years, including Houston, Boston, Dallas-Fort Worth, San Francisco and San Jose. Texas alone accounts for nearly 20% of construction under way, followed by California at about 11%, more than half of which is in San Francisco and San Jose.

Unsurprisingly, construction activity in the primary ICEE markets is more than double that of the primary FIRE markets: 25.5m sqft and 12.1m sqft, respectively.

Looking at the 87 markets that Colliers covers, supply-side pressure remains low, with the amount of square footage under construction in Q2 2013 representing just 1.2% of existing inventory. Because of the relatively slow recovery in the US, space under construction represented less than 1% of existing stock, compared with 3.9% in Canada where economic expansion is more advanced.

Much of the space is ‘build to suit’ in response to a lack of suitable space. New and renovated office space is being used as a recruiting tool as the competition for skilled workers in the technology and energy industries intensifies. For example, energy firms in Houston are seeking newly constructed, LEED-certified buildings to attract talent from both within and outside the metropolitan area.

Although still low in most markets, speculative construction is picking up in markets with the strongest demand. Developers recently announced planned groundbreakings on the 22 Waugh and Two Hughes Landing projects in Houston. Also, Hines recently broke ground on 1601 Wewatta, a speculative class-A building in the LoDo area of Denver.

With vacancy rates still elevated in many office markets, we expect speculative construction activity to continue to be focused on the strongest sub-markets in select metropolitan areas. We also expect construction to commence on more projects that were put on hold during the recession as rising rents and demand for high-quality space support development activity.

Oliver McMillan recently announced that it will build 86,000 sqft of office space for growing apparel company Spanx at the former site of the Streets of Buckhead project, a large mixed-use development that stalled during the recession.

US office transaction volume surged by 21% quarter-over-quarter and 36% year-over-year to $20.2bn (€12.1bn) in Q2 2013, as fears regarding sequestration and other factors that constrained investment activity in Q1 2013 were alleviated. This total was the highest second-quarter transaction volume since 2007.

The large amount of available capital supported several high-dollar transactions, including several $1bn-plus deals, mostly in Manhattan, after just one between the fall of 2008 and year-end 2012, according to Real Capital Analytics.

Texas is also attracting a growing amount of outside investor interest due to its robust economic growth, as indicated by Cousins Properties’ recent acquisition of two office towers in Houston and Fort Worth for a total of $1.1bn.

Investors are moving further out on the risk spectrum in terms of property location and asset type in search of higher yields, which we expect to continue as the economic recovery broadens to include more markets and industries.

Greater risk tolerance and sustained economic growth should fuel further transactions during the second half of 2013. Signs of a probable reduction in the Fed’s bond-buying programmes later this year led to an interest-rate spike in May and June, fostering considerable fears regarding future commercial real estate values.

However, we believe that the reduction in bond purchases is positive, as it shows the economy is healthy enough to grow without Fed stimulus. Even with the recent interest rate spike, the spread between average office cap rates and the 10-year Treasury is still historically wide, at 400–500bps, meaning that there is a cushion to absorb higher interest rates.

Office investment still offers an attractive risk-adjusted return and continues to draw investors from the multifamily sector and other asset classes. Also, we expect continued economic improvement and recovery in office market fundamentals to support higher NOI, helping to offset the increase in interest rates.

Andrea Cross is USA offices research manager at Colliers International