The outlook of the office and apartment commercial real estate sectors paints two different pictures, according to the latest research from Ten-X.
In the office sector, a broad national outlook obscures the bifurcation of two types of markets – ones that are lagging (the “left behinds,” as Peter Muoio, chief economist at digital real estate marketplace Ten-X, calls them), and others whose economies are strong (“hot markets,” in Muoio’s words).
While the office sector outlook is market-specific, there has been, with some variation, a nationwide trend in the apartment sector: a heavy influx of supply responding to steady but healthy demand and extremely low vacancy rates, resulting in strong increases in rent.
A multitude of factors is contributing to these trends on a macro level, including the evolving workspace dynamic, the economic outlook under the administration of President Donald Trump and the aging of millennials.
Here’s a closer look at these two commercial real estate sectors.
Office
Ten-X research indicates that on a national level, the office sector is experiencing a tepid recovery that has continued so far this year.
“Weak demand, not a lot of supply, little movement in vacancy rates,” Muoio said.
But underneath the national level lies two types of markets that are in different places in the recovery cycle.
With slow economic growth and job creation, the “left behinds” are in pretty much the same place they were when the recession ended. Much of the Midwest, including Chicago, fits into this category, according to Muoio. So do New York City’s suburbs, which is a reversal of the city/suburb dynamic of previous decades.
New supply has lagged in these markets, because demand is weak and vacancies are high, and rents remain low.
In the “hot markets” of New York City, the San Francisco Bay Area and the Raleigh-Durham area in North Carolina, to name a few, strong economies and job growth have led to low vacancy rates and increases in rent. But the stream of new supply that has followed has had a cooling effect on these “hot markets.”
“While the demand side still looks good, the supply side is now threatening the continued recovery of those markets as the completions are coming online,” Muoio said,
No matter the market, the changing dynamic of the workspace is inhibiting demand. Because of open floor plans, people sharing desks and working remotely and cloud servers, there’s simply less office space needed these days.
In 2010, according to Ten-X research, the average square foot planned per worker was 225 sq. ft. By 2012, it was down to about 175 sq. ft. The estimate for this year is just north of 150.
“In just this cycle so far, you’ve basically reduced the space per worker by a third,” Muoio said. “So the secular headwind, as we keep referring to it, or the shrinkage of space per worker, works against any cyclical gains you’re getting from office job creation.”
Apartments
A massive decline in home ownership has led to increased demand for apartments, a trend more national in scope than what the office sector is experiencing, according to Muoio.
Home ownership peaked at 69.2 percent in June 2004, the percentage of Americans who own their own homes plummeted to 62.9 percent by the second quarter of 2016, the lowest it’s been since 1965, according to Census Bureau information. Home ownership showed modest recovery to 63.6 percent in the first quarter of this year.
“Every percentage point change in that home ownership wave is about 1.2 million households shifting from owning a home to renting a unit,” Muoio said, “so that’s been massive across the board.”
Even as supply has picked up in the apartment sector, robust demand has kept vacancies low in most markets, hovering just above 4 percent nationally for about two-and-a-half years.
There is some variation across markets, though, as the supply uptick has been more dramatic in markets such as New York, Miami, Seattle and the Bay Area. Supply is so intense in these markets that it is straining apartment fundamentals.
“We still can’t come to grips with there being enough demand to fully meet all that supply,” Muoio said.
These markets are dealing with a “digestion issue,” he added. “They’re still healthy, there’s still a lot of demand, but there’s such an intense delivery of units coming on over the next several years, maybe into 2019, that they’re going to see bumps in vacancy rates.”
Another variation within the national trend is occurring in what Muoio calls the “post-housing bust markets” – Atlanta, Florida, Phoenix, Las Vegas, and Sacramento and Riverside/San Bernardino in California, for example. These markets were hit so hard by the housing bust that they were treated as toxic for years after by lenders and builders.
Recovery has been slower in these places, but their economies have started to strengthen, fueled largely by a rejuvenated flow of people moving from the Northeast and Midwest to the Southeast and West.
Still, the supply pipelines have been slower to fill in the post-housing bust markets, according to Muoio. Construction has picked up, but not with the intensity of hot markets such as New York and Seattle.
The post-housing bust markets “are sitting in an earlier segment of their cycle, but they’re seeing strengthening demand and not as much supply. Their outlook is much more positive than some of these other markets,” Muoio said.
While Muoio predicts home ownership will remain around its current level for another two to three years, millennials could provide a boost, should they move from city apartments to houses in the suburbs.
Such a trend could be triggered when these younger folks start looking for the best schools for their children. Countering the desire to put their kids in certain schools, though, is the notion that millennials are jaded by the thought of home ownership – they grew up in the middle of the housing bust, after all.
Muoio has his eye on “urban-like suburban markets” – walkable, mixed-use developments near transit hubs. “If we start to see more of these types of developments, the office sector, as well as apartments, would be affected, because businesses would become interested in setting up shop where their potential employees live.
“My guess is it’s going to be a mix,” Muoio said. “You’ll still see rental, but it’ll shift perhaps from urban to suburban-like urban, as well as some shift at that later date to home ownership (as millennials get older).”
The Trump effect
Muoio pointed to “several seemingly unrelated federal policies under the new administration” that are combining to drive up construction costs considerably.
Under Trump, we are in a rising interest rate environment, and his emphasis on infrastructure improvements and his charge to build a wall along the Mexican border have the potential to drive up demand, and therefore cost, for both materials and labor. A tariff on steel imported from China would also increase the cost of materials.
Additionally, changes in immigration policy could limit the number workers available to the construction industry – about 13 percent of U.S. construction workers are immigrants, second only to agriculture, Muoio said.
“You have all these very disparate policies, none of which anyone woke up one day and said, ‘Let’s drive up the cost of development,’ but combined, could have a very real impact. Rising interest rates work against both buyers and developers, but the materials and labor cost issues change the equation of build vs. buy.”
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