The cyclicality of real estate development is especially prevalent in the office property type. High potential returns per project have historically attracted speculative developers, meaning no tenants have committed to the space. There is a lengthy time lag between the planning and occupancy stages, including permitting, raising capital, and long construction times. Market equilibrium is difficult to achieve in the office sector because the economy could be very different at completion than when the plans were initially approved.
Come On Baby, Let's Go Downtown
With high stabilized yields, a suburban project with low land costs and a long term lease in-hand can seem like a slam dunk. The project may be a success for a five year hold, and possibly ten years. However, re-tenanting a suburban office project can prove difficult and expensive. Assuming the tenant's business stays healthy (a bold assumption), the tenant may shift its business model or new management may want to move to a different suburb, or even to the Central Business District, or CBD. Additionally, the ability to attract and retain top employees is increasingly influenced by a modern office layout and travel time to good residential neighborhoods and amenities. Even if the tenant doesn't leave, the threat can cause the landlord to cut rents and offer large tenant improvement (TI's) packages to avoid an extended period of receiving no rent. The alternative is normally characterized with a period of vacancy and high costs to attract another tenant. Ultimately, the suburban office business does not normally give the landlord very much bargaining power, and timing the market consistently is difficult, if not impossible.
In contrast, CBD office buildings have significant land costs, more diverse tenant bases, more expensive rents, and a lower threat of new supply. The higher land costs necessitate greater density resulting in taller buildings and more costly rents to justify development. Typically, the elevated development costs can result in higher dollar gains, which attract a more sophisticated investor base. The assumption is that large capital pools have educated investment committees that understand the risk of office development and the long term costs of maintaining and managing the finished product. The result of relatively more disciplined development is shown in Figure 1, which graphs the vacancy and historical completions of the two office categories. CBD office buildings experience more muted peaks and troughs in comparison to their counterparts. The central locations near residential neighborhoods that are persistently desirable attract talent from all levels, but especially at the decision-maker level. The more diverse tenant base makes re-tenanting much more manageable, especially if the tenant is a smaller portion of the total rent in the building.
Don't Build it if They Won't Come
Given their access to capital, commitment to a dividend, and perpetual life, public REITs are generally prudent developers, especially in the office space. REITs have access to capital throughout the cycle, not just when the market is hot. Also, they plan to be long term holders of the property so they are concerned about durability and the tenant roster to minimize operating expenses such as maintenance capital expenditures and re-leasing costs. Finally, their commitment to paying a quarterly dividend restricts their ability to invest too much capital on speculative development projects, which essentially are non-earning assets. For capital allocation purposes, REITs will compare the return expected on development to the immediate cash yield available from acquiring a building, requiring a significant premium from the development to justify the risk.
Due to the financial market turmoil in 2008-2009, very few office construction projects were able to be financed in the past 5 years. As a result, 2012 was one of the lowest years on record for new office completions, and 2013 was only slightly higher at close to 0.8% of existing stock, a far cry from the 1.7% average since 1988. Since 2008, the capital markets have become more disciplined, requiring more equity and pre-leasing to finance construction loans. As such, the markets with the most square feet under construction (San Francisco, New York, Houston) are those that are currently experiencing the highest job growth.
Optimization of Demand
Despite a positive environment for landlords given the low new supply, the office sector has to consider how tenants are thinking differently about office space. The ability to telecommute via remote internet connections combined with rising rents have motivated companies to optimize their use of space. Figure 2 shows how significantly firms have decreased the space per employee in the past 30 years, a trend that CBRE believes will continue through 2017.
However, rents have continued to increase, reflecting higher occupancy rates, rising replacement costs, and fewer suitable alternatives in many submarkets. The country has moved to a service-driven economy, increasing the number of jobs that require an office (Professional & Business Services and Finance & Real Estate). Because businesses are now looking at their leasing expenses on a per employee basis, they have been able to pay higher rent per square foot. (click to enlarge)
At the end of the day, demand for office space is still a byproduct of hiring, and the correlation between net absorption and office-using job growth is relatively high. Though the employment gains are not on par with historical recoveries, we are currently in a period of slow job growth, which will create pockets of rental rate strength where demand is greater than supply.
High Tech Companies are Picky
Growth in the tech sector has been driving the demand and subsequent development for office space in several markets. According to CBRE, High-Tech was the biggest contributor to nationwide leasing for the year through September 30, 2013. California, particularly San Francisco and West LA, continues to be synonymous with tech as 32% of all leases signed in the Western region were tech-related. With the lowest average age of employees, the tech sector is literally shaping office development. Younger employees want to work in buildings in vibrant urban neighborhoods with larger floor plates and open areas, more conference and meeting rooms, and fewer separate offices. The new space demands have made many older buildings obsolete, which shrinks the potential supply further, and thereby places upward pressure on rents in viable buildings.
Among office REITs today, Kilroy Realty (NYSE: KRC) is the most active developer with a development pipeline that would expand their real estate owned by 26%. KRC concentrates on the West Coast, and is in the process of a major portfolio transformation. The company has focused on developing and redeveloping buildings into collaborative workspaces that inspire creativity and feel a little less like work. Their pursuit of LEED certifications for all new buildings also appeals to the millennial generation's desire to minimize impact on the environment. As a result of these initiatives along with a first mover advantage, KRC has attracted large leases from companies like SquareTrade, SalesForce, and LinkedIn. Seattle, San Francisco, Silicon Valley, and West Los Angeles have become hotbeds for these companies, and, thanks to their balance sheets and access to the capital markets, the REITs have been on the forefront of office development to fan the flames.
For the entire West Coast, the biggest potential skyline changer is Boston Properties' (NYSE: BXP) project at Transbay in the South of Market (or SOMA) district of San Francisco. With development costs over $1 billion, the tower would be the tallest on the West Coast with over 1.4mm sqft of rentable space. BXP paid $190 million just for the land! However, the building is not expected to deliver until 2017, which therefore leaves uncertainty as to what the leasing environment will be upon completion. As we would expect from a high caliber REIT management team, the company is waiting to achieve sufficient demand for the space before going forward with the project.
Wheels Finally Moving On This Cycle
Looking out to 2018, Green Street Advisors projects demand growth of 7.4% and supply growth of only 6.7%, which would create estimated rental growth of 25%. High barrier markets like San Francisco and West LA are projected to have rent growth of close to 35% over that time period, while the low barrier markets are projected to be much closer to the national average.
Despite the obvious risks to owning office buildings, such as inflation in operating expenses, reduction in demand due to the decline in government spending, the shrinking financial sector, and decreasing square feet per employee, the outlook for the sector appears promising after a slow recovery from the 2008 recession. The tech sector has been picking up the slack from government and finance, driving employment upward. As shown in Figure 4, the relationship is strong between employment and office demand. Importantly, the office REITs are experiencing accelerating same store net operating income (SS NOI) growth, while short lease sectors like apartments and storage are decelerating. REITs that are focused on high barrier submarkets will be beneficiaries of a US office sector in the early innings of a long term recovery propelled by historically low new supply.
The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.