Has the business cycle run its course, or does it have legs for a few more years? Has the stock market peaked again? What about commercial Real Estate? Is it different this time? What might derail the market this time? Is it the shift of private debt to national debt? Will it be the raising of interest rates by the Fed? Or something we just don’t see yet?
As you know we publish quarterly reports on the status of commercial real estate, specifically in regard to office space. The market has been on a terror as of late with rental rates spiking in many high-end markets across the country and locally. New product is being delivered to the market and there is a ton in the pipeline. But it can’t get here soon enough. Not all of the proposed buildings will be built, but there are some pretty big players about to make large bets on the office market continuing its ascent.
Why did developers wait until now? It takes fairly high rents to justify new development, and those rents are just now materializing. Businesses are adding jobs and leasing additional space, so vacancy rates are decreasing. Construction costs are high and continuing to escalate due to a few reasons, including new Title 24 and environmental regulations, labor costs, and of course the fact that everyone wants to build at the same time. The good news: commodity prices like copper and oil are down.
So, where are we in the business cycle? I spent some time analyzing the last three market cycles in both Orange and Los Angeles County dating back to 1997. I focused on Class A Office Vacancy, Rental Rates, and New Building Delivery and compared the statistics with the Dow Jones Industrial Average and each county’s respective employment. I graphed these items and found that in the dot com crash and the Great Recession, class A office vacancy rates peaked 2.5 years after the Dow Industrials peaked. Unemployment increased in both of these downturns the first quarter after the same correction. Interestingly, unemployment in Orange County also increased within a quarter of the latest stock market correction. Los Angeles also seems to have slowed it’s hiring slightly.
Is there a correlation between the last two cycles and this one? I think so. The last 3 stock market downturns, including this latest correction, came 8 years apart, and as mentioned above, hiring slowed almost immediately. The difference this time may be that new office product is being delivered to the market at a more measured pace. However, there are many proposed projects planned for construction in the 1st quarter of 2016. If only half of the proposed class A office projects start, it could get very messy again by late 2017, ironically 2.5 years after the Dow Industrials recent peak. A tenant market would surely ensue thereafter, or even prior to that date.
So, what are tenants to do in the meantime? Rates are moving up fast and tenants are competing for space. We are moving squarely into a “landlord market” in many desirable sub-markets. That being said, vacancy rates are not nearly as low as they have been in previous cycles. Will it tighten much more? I think so. The class A office market will tighten until more new product is delivered, or until some unforeseen macroeconomic issues weigh on the market. Interestingly, the unemployment rate is not quite as low as it was in previous cycles, but it is close (and then there is the very low labor participation rate…). My suggestion is always to make decisions that make sense for the strategic direction of your company. If you can wait out the market and get by for a couple years on a short-term lease, you may find yourself in the catbird seat. If you can’t, lock down some space quickly!
Since this blog is already to long… Quick Stats:
LA Class A Office Vacancy: 14.3%, LA Class A Office Asking Rents: $2.85
OC Class A Office Vacancy: 12.2%, OC Class A Office Asking Rents: $2.46 (although this number is actually higher in reality due to so many landlords quoting rates as “Negotiable.”