Before the pandemic rattled the U.S. office market, a trend of focused leasing demand developed that has since carried through the pandemic and remains one of the strongest drivers of leasing. Both owners and occupiers have concentrated on a flight to quality when developing new buildings or selecting locations for their new offices. The buildings both parties look for are typically new construction, well located particularly near public transportation or major throughfares, and contain high-quality amenities.
According to CBRE research, Q4 2022 marked the first quarter of negative net absorption (5.9 million sq ft) since Q3 2021. Demand was much weaker in buildings constructed prior to 2010, highlighting part of the flight to quality trend in the market, while positive demand was realized in newer buildings. This is not a new phenomenon, as the U.S. office market went through a similar trend coming out of the 2008 financial crisis. The chart below from JLL shows the similarities between today’s leasing climate and 2010’s as it pertains to buildings delivered within the previous 5 years. Availability in newly constructed buildings is significantly lower than those in the overall market constructed 5+ years prior to the analysis. This time around, the spread between availability in newly delivered buildings and the overall market has increased from 8.4 percentage points to 12.5 percentage points.
Source: JLL Research
Note: Availability rates differ from vacancy rates by removing leased space that has yet to be occupied from available inventory.
Top-tier office buildings, considered Class A or Trophy assets, have demanded higher rents than the rest of the market. In higher inflationary times, rents can often be diluted by the increase in construction build out costs or operating expenses. Despite these challenging conditions, higher-quality assets have been able to increase their effective rates, meaning landlords have been able to stay ahead of rising concessions in free rent and tenant improvements. The chart below from CBRE illustrates how top-tier office buildings have been able to increase their effective rates when compared to lower-tier assets that do not have as much to offer the tenant base and therefore garner less rent while still having to compete on similar concessions.
Annual Effective Rent Growth by Type
Source: CBRE Research, Q2 2022.
On the tenant side of the market, occupiers have taken the pandemic as a chance to reevaluate their office needs. Often times, companies would use their office space as a way of attracting top talent for employment. Some called it an amenities arms race, to build out unique office amenities ranging from spa quality fitness centers to extravagant rooftop event space to 5 star hotel level concierges. Companies would use the amenities of these high-quality office buildings as part of their pitch for employee perks. The pandemic brought on a chance for tenants to right-size their space to accommodate for requirements like location, hybrid work, and purposeful collaboration. The chart below from JLL highlights different industry’s propensity for downsizing in today’s environment. All industries are in the process of downsizing their leased space, with technology being the only outlier. Newer office buildings are regularly the beneficiaries of these downsizes as they often have more efficient layouts and offer the high-quality amenities tenants are demanding.
Source: JLL Research.
Note: Total footprint refers to office space leased or owned for occupancy minus active sublease listings.
In a challenging leasing environment with such ebbs and flows, positive demand for high-quality, newly constructed, and conveniently located buildings with desired amenities remains a strong constant.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Vice President, Asset Management
Boyd Watterson Asset Management, LLC