Is There an Office Construction ‘Tsunami’?
In past real estate cycles, developers have overbuilt just as the economy slowed down, leading to a glut of space. But Cushman & Wakefield Principal Economist Ken McCarthy predicts history will not repeat itself this time.
“We saw it in 2008, in 2001 and, most dramatically, in 1991, when the overbuilding was so substantial it took almost five years to work through,” McCarthy said in a special report, Is an Office Construction Tsunami Coming? “It happens every time, or so it seems. The commercial real estate industry is one of the most dramatically cyclical in the economy.”
Situs RERC, Houston, reported national employment growth–especially in office-using occupations such as business and professional services–remained strong through 2017. “As the economy reaches full employment, the employment growth rate is expected to continue declining in 2018 and the office sector will remain a top investment destination because of the stability of the sector,” the company’s 2018 Real Estate Report said.
But the office sector faces some headwinds, Situs noted. “The combination of low interest rates and investor demand for the safety of Class A properties in prime markets has led to a flood of capital, both foreign and domestic, which has driven up prices in gateway markets,” the report said. “Also, many institutional investors are holding onto top properties in core markets, resulting in a lack of available product and further driving up prices.”
McCarthy said the current economic expansion is nearly nine years old and shows no sign of stopping and cited a “surge” in new construction. “On the face of it, it looks like the industry is headed toward the same over-building mistake,” he said, noting 103 million square feet of office space under construction in the 87 markets Cushman tracks. More than 54 million square feet of office space delivered in those markets in 2017, meaning the total amount of space to be delivered between 2017 and 2020 could exceed 150 million square feet.
“At first blush, this seems like a huge pipeline and indeed, if it was all dumped on the U.S. market tomorrow, it would push the vacancy rate up by 280 basis points, bringing it back to the level of late 2012,” McCarthy said. “However, there are balancing factors. The new supply will be completed over a period of at least three to five years, and while the new office space is being completed, jobs to fill at least some and probably most of that space are expected to be created.”
McCarthy estimated employment in office-using industries will increase by more than one million jobs over the next three years. “In addition, some of the new construction is buildings that have been taken out of inventory and are being redeveloped,” he said. “These are not net new additions.”
Although the numbers are large, the amount of new office construction was actually much larger in the mid-2000s and the late 1990s, McCarthy said.
“Even though the numbers are high, new office construction has been relatively constrained in the current cycle compared to previous cycles and does not appear to be getting out of hand,” McCarthy said. “The markets experiencing the largest volume of new construction tend to be the healthiest in the nation in terms of both jobs and office fundamentals.”
In addition, many of these markets need new construction, McCarthy said. “In New York, Washington D.C., and San Francisco, new office stock is a welcome addition to an aging and less globally competitive inventory of buildings.”
At some point, the economy will soften and the real estate cycle will turn downward, McCarthy said. “But the markets that are experiencing the most new construction are also among the healthiest in the nation, which suggests that the next down cycle, when it does come, will not be as severe as some of the past real estate cycles.”
