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Office Construction Extends Recovery, Nearly Matches Demand

Office market remarkably 'in tune' as new construction nearly meets lower demand.

This article was originally published by CoStar; view the original article here.

The 135 million square feet of office space under construction across the U.S. at the end of the third quarter only modestly exceeds the long-term historical average of 127 million square feet.

Office construction has remained surprisingly 'in tune' with market demand, avoiding the boom and bust cycles seen in 2007, when 187 million square feet was under way; and the whopping 250 million square feet that was under construction in the first three quarters of 2000, according to CoStar Portfolio Strategy data.

Despite healthy office fundamentals, record rent levels in many markets and healthy pricing achieved by new assets, "there is surprisingly little development taking place," noted Jeff Myers, managing consultant with CoStar Portfolio Strategy. "The overwhelming majority of metros are adding space at rates below their historical average," Myers added.

With new-found discipline of lenders and develoeprs, office construction has been closley tracking demand and remained well below historical levels since 2011, with less than half as much vacant new space available at midyear 2016 versus 2007.

While previous supply peaks from the late 1980s through the financial crisis of 2007 were marked by heavy speculative construction and dramatic rent spikes, many developers and lenders remain leery about launching spec projects, noted Michael Roessle, national director of office research for Colliers International.

In fact, some analysts believe overall U.S. office construction may be peaking for this cycle, with most projects now under construction in a handful high-demand markets slated for delivery in 2017 and 2018.

At the end of the third quarter, the top 10 markets in total office square footage under construction accounted for 56% of the U.S. total, with high concentrations of activity in Dallas, New York City's Manhattan, Silicon Valley, Seattle and Denver, Roessle said.

"Construction totals have crept higher in recent quarters but seem to be leveling out," according to Robert Bach, director of office research for Newmark Grubb Knight Frank, pointing out that construction as a percentage of total stock is currently about 2%, -- well below the 2.8% going into the 2007-2009 recession and the 3.6% under construction before the 2001 recession -- not to mention the eye-popping 13% of total office inventory under construction prior to the recession of 1990-1991.

Bach believes the leveling out is due in part to tighter lending standards as a result of actions by bank regulators, who about a year ago began requiring higher capital reserves for so-called "high-velocity CRE loans," including construction financing.

The new rules appear to be having the desired impact, Bach said, in keeping construction from getting out of hand as in some previous cycles.

Rising construction costs are also likely impacting developers’ aspirations, with multiple construction cost indices showing that the price to build has risen faster than office rents during the recovery, CoStar's Myers added.

Q216Officesupply

The supply and demand balance is most evident in the major gateway markets where new supply is appears to be nearing an inflection point in occupancy and rent growth as new supply begins to catch up, particularly in CBD districts where millennials want to live and work.

More than 60% of the current office development pipeline is expected to reach completion in 2017. As a result, leasing conditions are expected to balance out during 2018 and take a strong turn in favor of tenants by 2019, forecasts Julia Georgules, director of office research for Jones Lang LaSalle.

In another sign of the market in balance, office tenants had absorbed nearly 100% of the space delivered in the first three quarters of 2016, Georgules added.

"Firms are adding space, but at a more modest pace than in recent years, reflecting slower overall job creation," says Jeffrey Havsy, chief economist for CBRE Americas. "With supply and demand relatively in balance, vacancy has plateaued for the moment but the office market should remain healthy as new construction deliveries slow over the next 6-8 quarters."