11/06/2013 | by

Whether the U.S. economy is experiencing a “jobless recovery” is up for debate. What is not, however, is that hiring by businesses has been lackluster as they continue the long road back from the financial crisis.

With the economy adding short of 200,000 jobs a month on average, the key driver of demand for office space is keeping the sector’s recovery muted.

“This far into an economic recovery, we should be doing much better than that,” says Alexander Goldfarb, a senior REIT analyst with Sandler O’Neill + Partners. “In this sort of environment where businesses are dealing with new regulation and the threat of new investigation by the government, businesses just aren’t hiring the way they normally would, and that’s filtering down.”

Although demand for office space nationwide is not robust in this environment, certain central business district (CBD) markets have escaped the malaise.

Looking Behind the Growth

Walter Page, CoStar’s director of office research, sees some commonalities in the CBD markets that are expanding fastest.

“Some of these are technology-dominated markets,” he says. “Others are financial services-dominated markets. Three are manufacturing-driven, and three are broadly diversified. And, typically, they are in areas of population growth.”

Sector: Office
Constituents: 19
One-Year Return: 4.99%
Three-Year Return: 9.78%
Five-Year Return: 7.98%
Dividend Yield: 3.44%
Market Cap: 58,662.2
Avg. Daily Volume (shares): 729.2 million
Source: NAREIT. Data as of Oct. 1, 2013

In San Francisco, Raleigh, Seattle and Boston, technology-related fields such as social media and biotechnology are driving demand for CBD office space from the firms that provide services to the tech firms. These include financial services companies and law firms. Demand has arisen due to the presence of software and Internet giants, such as Microsoft, Google and Amazon. There is also demand due to the growth of media companies such as YouTube and Netflix, as well as social media standout Twitter.

“The technology industry – social media technology and media in general – has driven those areas from an absorption standpoint, because there are jobs,” says Victor Coleman, CEO of Hudson Pacific Properties (NYSE: HPP), a Los Angeles-based REIT that owns office properties in San Francisco, Seattle and San Diego. The employment numbers are high. Both those marketplaces have a very great demand for a live-work environment.”

The impact of the financial services industry can be found in markets like Charlotte, where there is demand for CBD office space due to the presence of Bank of America and other banking and financial firms. This has also created demand for CBD office space from legal services firms and utilities firms. Similarly, financial services tenants are driving demand in the Florida markets of Tampa, Miami and Jacksonville, according to Page.

Some of the areas out west – including Phoenix, San Diego and Portland – have expanded as a result of the growth in a variety of diversified industries that has led to office space demand from financial and legal services firms in addition to state and local government agencies.

“As the broader U.S. economy does better, these markets just do better,” Page says. “And because these markets tend to have above-average growth rates anyway, they are showing signs of recovery better than the nation.”

Recovery in the housing market means increased need for space from mortgage lenders and appraisers. That has certainly helped the Sun Belt markets of Phoenix and Miami, which are growing population-wise. Meanwhile, in Oklahoma City, growth has been driven by the energy and natural resources industries.

Of the top performers, perhaps the most surprising would be the Rust Belt cities of Milwaukee, St. Louis and Detroit. These cities are benefitting from the attending demand that comes from the boost in manufacturing activity, particularly in the automobile and components industry in the case of Detroit. Despite the improving conditions, vacancies remain high in Detroit – above 17 percent in the second quarter of 2013.

Taking the Pulse of the Markets

While demand for space may not be growing at an eye-popping pace in some CBDs, that doesn’t necessarily mean offices are sitting vacant.

“In some of our markets, there’s not only extremely low direct vacancy, there’s almost no sub-tenancy availability,” says Mark Lammas, Hudson Pacific’s CFO. “In San Francisco the overall market is at almost an all-time low in terms of vacancy, at about 8.5 percent.”

Even so, rent growth has remained tepid for the most part, aside from San Francisco, which has witnessed year-over-year rents spike 10 percent, according to Page. In Seattle and Boston, rents have climbed 4 percent to 5 percent, with the other markets up 3 percent or less. Phoenix has remained flat.

Still, builders appear encouraged by the fact that there is some speculative construction going on.

“Landlords are being more conscientious, but it depends on the market,” Goldfarb says. “For smaller buildings in San Francisco, people are willing to put up speculative space, because there is meaningful demand. So, if you are building a smaller building, like a 300,000-square-foot building, even though it may be speculative at the moment, you feel pretty good that you will be able to lease it up by the time construction finishes.”

For investors looking to get into the office sector, some office REITs that have significant exposure to the fastest-growing CBDs could offer appealing potential returns. In addition to Hudson Pacific Properties, this group include Boston Properties (NYSE: BXP), Kilroy Realty (NYSE: KRC) and Parkway Properties (NYSE:PKY), Highwoods Properties (NYSE: HIW), CommonWealth REIT (NYSE: CWH) and Alexandria Real Estate (NYSE: ARE). According to CoStar, these REITs have the largest rentable building areas, as a percentage of their portfolio by square feet, in the growing CBDs.

Coleman notes that he expects his company to benefit from the growth in its markets for some time to come.

“Clearly these markets are in extremely high demand,” he says. “Markets don’t just change overnight from being in demand to not. We’re talking about markets where you’ve got three to four years of quarterly growth. It may not continue at the same rapid pace, but they’re not going to fall off either.”


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