01/30/2014 | by
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After an extended period of underperformance, fundamentals in the office sector appear to be moving in the right direction. However, the pace of improvement does not match past recoveries, according to industry observers.

The first month of 2014 has offered positive signs for the sector. So far this year, total returns for office sector REITs are up 2.4 percent, compared to 1.4 percent for the FTSE NAREIT All Equity REITs Index.

Greg Adams, director of BDO Valuation Advisors’ national real estate practice, which values both domestic and foreign real estate, noted that in prime markets such as Boston, New York and San Francisco, investors are modeling rent spikes into their cash flows. “You’ll see maybe a 5 or 10 percent rent spike in year two or three, instead of the typical 2 or 3 percent rate of inflation rent spike,” he said. In those stronger markets, “there’s more demand for the space, it’s becoming more of a landlord’s market where they are able to increase rents and offer lower tenant improvement dollars,” Adams noted.

According to commercial real estate services provider Cassidy Turley, vacancy rates in the fourth quarter fell 20 basis points to 15.1 percent, compared with a recessionary peak of 17.3 percent. Kevin Thorpe, chief economist at Cassidy Turley, noted that “office vacancy is clearly tightening, but at a rate that is much slower than past recoveries.”

“Steady job growth and lack of new development has vacancy falling in 70 percent of the country, but the office sector is still adjusting to the new era of tenant downsizing and space efficiency,” he said.

Michael Knott, managing director at Green Street Advisors, believes many of the challenges facing the sector, such as the reduction in work space per employee and lackluster job growth, are no longer major hindrances.

The move to downsize work space has been a mainstream trend for several years now, according to Knott, “so we’re at least in the middle of this headwind, if not even a little bit later.” Meanwhile,  Knott said office demand should now move more in line with overall employment  growth, which  Green Street expects to remain in the range of 150,000 to 200,000 jobs per month.

However, Knott added that demand growth is not going to outstrip new supply by all that much. While new supply has been a fraction of what it’s been in the past, Knott observed that “confidence has grown just enough where new construction feels like it’s becoming something that industry isn’t shying away from as much as it was the past few years.”

Fueled by growth in the tech and energy sectors, the San Francisco Bay Area, Austin and Houston are “the clear poster children for why new construction has been happening over the past couple of years,” Knott said.

Thorpe noted that while rent growth is still being fueled by the energy and tech markets, it is being felt more broadly. “Supply-demand fundamentals suggest the majority of the country will be pushing office rents upward by this same time next year,” he said.

Green Street’s Knott said there will not be a meaningful reduction in overall U.S. office vacancy over the next few years, “but I think it will be good enough to continue moving fundamentals in the right direction and hopefully to start seeing some rent growth.”

“It’s a more challenging business than many real estate property types,” Knott said. “But I think that looking forward from this point, there’s more optimism than there was over the past couple of years… It’s not a rosy outlook, but it’s a more cautiously optimistic outlook,” he observed.