US employment drives recovery
In the US, the office market is already showing strong signs of recovery, with the national office vacancy rate, which peaked in 2003, gradually descending and rents on new leases bottoming out in the majority of markets. Because the office market follows employment trends, indications for the market’s future are good: since August 2003, when US employment reached a low point, 1.7m jobs have been created, and by early 2005 all jobs lost since March 2001 - a total of 2.7m - will have been recaptured. This employment recovery will generate demand for office space and create investment opportunities in many US markets.
The US real estate market are organised into seven clusters comprising thirty-five key cities. Clusters are based on salient characteristics: economic structures like growth and industry distribution, geography, and a desire to have clusters of reasonable size. The relatively small number of clusters helps to simplify a diverse US marketplace.
Each of these seven clusters has some fundamental quality that all of its markets share and is anchored by one or two major cities. They are:
q Capital Metro, anchored by Washington, DC, due to its unique status as the US capital and resistance to economic downturns;
q New York Corridor, anchored by New York, the most important financial centre in the world;
q Tech Centres, anchored by Boston and the San Francisco Bay Area, due to the high prevalence of technology and life sciences companies;
q Southern Growth, anchored by Atlanta and Dallas, due to a balanced economy and vibrant growth;
q Heartland, anchored by Chicago, the traditional industrial centre of the US;
q Lifestyle Centres, anchored by south east Florida, due to their warm climates, domestic migration inflows, and large numbers of retired people;
q Southern California, anchored by Los Angeles, important because of its role in Asian maritime trade.
Taken together, these seven clusters represent 94.5% of the total National Council of Real Estate Investment Fiduciaries (NCREIF) investments. Therefore, this framework not only classifies different markets but is also comprehensive in its coverage of almost the entire US institutional market. The remaining 5.5% is in small, opportunistic markets. The nine anchor cities alone represent 65% of total NCREIF investments and 72% of NCREIF office investments.
After peaking in the late 1990s, new office supply has fallen since 2001. Over the next few years, office supply in the US will be limited, until demand increases and vacancy rates decline.
From the peak employment level in March 2001 to the trough employment level in August 2003, 2.7m jobs were lost before employment began increasing. This had a pronounced effect on office demand. As employment trends upward again and the economy strengthens, office demand is expected to recover. Logically, the increase in supply and sharp drop in demand drove office vacancy rates toward levels not witnessed since the early 1990s, during a severe market depression. The current constrained supply, coupled with increasing demand, should drive vacancy rates down in the next years.
Much like vacancy rates, the real rental rate now hovers slightly above the real rate seen during the early 1990s. Nominal and real rents are projected to gradually rise over the next few years, spurred on by increased demand. However, despite the rising rents in the office sector, for the next two years net operating income (NOI) is projected to continue the decline that began in 2002. Marginal rents are currently bottoming out. As the lucrative leases that were signed during the last boom cycle expire, leases at much lower rents will replace them, thereby suppressing NOI. The chart displays the pronounced fall and expected rise of rental rates as the market begins a recovery phase.
Over the next few years, the office market will enter a recovery phase, which has not been witnessed in the US since 1993-1997. After the last recovery, the market went through a maturation period, which was characterised by below-equilibrium vacancy rates, spiking rent rates, and widespread office development. All tenants, including dotcoms with suspect credit ratings, financial statements and business plans, signed leases at these high rates.
After the economy began to worsen, this trend completely reversed. Office market fundamentals deteriorated - vacancy rates climbed, rental rates declined, and supply growth slowed. The market entered into a credit phase, characterised by declining mortgage rates and a preference for high-credit tenants and long-term leases.
After these trying times, the market is set for another recovery period. As occupancy increases and rental rates rise, coupled with a limited supply and relatively little new construction, fundamentals will improve. As the economy grows and new jobs emerge, recovery play opportunities in the office sector arise because the new jobs create demand for office space. Given the current imbalance between supply of office space, demand growth will be vitally important to the performance of office markets.
With demand growth, and ultimately, office market performance dependant on job creation, it is of paramount importance to know where these new jobs will be created. The lifestyle and southern growth clusters are expected to have the highest employment growth rates among the clusters during the next three years. The lowest employment growth rates will likely be in the New York corridor and heartland clusters, with the remaining three clusters’ projected growth rates in the middle.
The recent job growth has led the US office market into recovery. Fundamentals in the office market have been improving and are likely to continue to do so for the next few years. Occupancy rates are rising and rents are increasing, while new supply will remain constrained. Opportunities will exist in markets that can capitalise on the employment growth quickly as supply and demand work their way back to a normal equilibrium level.
Although many of the markets in the southern growth and lifestyle clusters currently exhibit weak fundamentals, opportunistic investments will arise because of the strength of the employment growth. Recovery play opportunities could still occur in other clusters, particularly the ones exhibiting more stable fundamentals, such as the New York corridor and capital metro. Even the clusters with the lowest projected employment growth rates are expected to create hundreds of thousands of new jobs over the next three years. Ultimately, pricing and an investor’s current holdings will determine the decision regarding which cluster(s) to invest in.
Roger Pratt is a managing director and senior portfolio manager and Ryan Severino, director, investment research at Pramerica Real Estate Investors