Dive Brief:
- U.S. office demand continued to improve in the third quarter despite volatile macroeconomic conditions, with each of the last four quarters seeing more leasing activity than any single quarter since 2019, JLL said in its Q3 office report.
- Leasing volume rose 6.4% year over year, led by gateway markets, which saw activity jump 13% in that time. The market absorbed 6 million square feet of space in Q3 while 9.6 million square feet was converted or redeveloped, in part due to many office buildings being repurposed, particularly in the Midwest.
- Effective rents for first-generation buildings have increased over 20% annually, underscoring heavy demand for top assets. At the same time, rents for second-generation buildings have risen over 10%, benefiting from growing spillover demand that can no longer be captured by a diminishing development pipeline.
Dive Insight:
Over the past 12 months, 19 markets exceeded 2019 leasing levels, with an additional nine markets surpassing 90% of those levels; tenant space requirements also exceed last year’s volume in major markets, “which points to continued strength for the next 12 months,” per the report.
Inventory fell to 21 million square feet, from over 45 million square feet in late 2023. Construction activity remains low. Only 3.5 million square feet of new office space was completed in Q3, matching near-record-low delivery volume from the prior quarter.
Multiple markets show potential to support new trophy development when rent-insensitive tenants face extreme supply constraints, “but at this stage that activity has not been occurring at the same rate that inventory continues to be removed from the market,” JLL says.
These factors are providing leverage for landlords in high-end segments, per the report.
Though asking rates marginally increased as landlords leverage expands more broadly across Class A markets, effective rents have grown “exceptionally quickly in trophy and new construction segments as space becomes extremely scarce in most markets,” JLL says.
Asking rent is the initial rental rate advertised by the landlord or broker, whereas effective rent is the adjusted rate that includes any rent-free periods and other incentives provided to the tenant.
“Despite the relatively diminutive rate of growth, asking rents are beginning to accelerate and grow at a pace that has not been seen since 2019,” growing 60 basis points quarter-over-quarter to $40.51 per square foot nationally, per the report.
In New York’s Midtown Manhattan market, for example, the average asking rent for Class A assets grew to $91.08 per square foot, the highest since the third quarter of 2008, according to Colliers. “Year-to-date demand reached its strongest level since 2000, availability declined to 12.4%, and Class A asking rents hit a record high,” a Colliers spokesperson said.
JLL says the top-down nature of occupier recovery is particularly evident when looking at effective rental rates based on pricing tranche, with rent growth significantly stronger in higher-priced segments.
Technology-led markets made a notable bounce-back in occupancy, with San Francisco, Austin, Texas, and New York showing year-to-date net absorption. Occupiers are also growing their footprints following downsizing in recent years, as the average footprint of signed leases grew 13% over the past 12 months, JLL said.
Though investment activity is improving in the office sector — up 13% year over year — the expectation of elevated interest rates appears to be slowing the pace of improvement, JLL says. Sales volume growth rates slowed from last year’s pace of +30% annual growth.
“The sharp shift in conditions could drive a moderate slowdown in Q4, particularly in sales activity, and potentially driving moderate delays in leasing transactions if the elevated interest rate environment persists,” JLL says. “Interest rate hikes will also extend the timeline for supply relief by further stifling new development and slowing the transfer of assets from financially-restricted owners to healthier ownership.”
In the Midwest, central business districts are experiencing the largest repositioning of office buildings, according to data from Newmark. Across 10 markets tracked by the firm in the region, 176 office properties totaling over 38 million square feet are either completed, under construction, proposed or under active speculation as candidates for conversion, the firm said Oct. 8.
“The buildings entering the conversion pipeline are overwhelmingly older, lower-tier assets,” Newmark says. The median building age at conversion is 106 years, with 70.3% of candidate properties built before 1945, most being Class B and Class C, it says.
“The key conclusion is the Midwest’s office conversion wave is not over. The 17.0 million SF-proposed-wildcard pipeline is nearly as large as the space already removed from office inventory,” Newmark says.
As of August, the pace of office sales where new buyers intended to renovate the buildings had been growing by nearly 30%, while the pace of sales where new buyers intended to convert the office to another property type were slowing,” JLL says. “That momentum may shift with materially different pricing dynamics.”
