Office Market Q4 2019 Projections
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Steady as She Goes
The Orange County office market is still in expansion mode, but key market metrics are showing signs of fatigue as we enter the final quarter of 2019. Results have been mixed throughout the year and a decrease in transaction volume, higher vacancy rate, and sporadic net absorption has fueled more speculation that a long-awaited correction may be coming soon.
Transaction Velocity has Decreased
A significant falloff in the number of transactions for the past three years has resulted in a corresponding decrease in total gross square footage leased. That has been compounded by the fact that companies are taking less space as they learn to leverage new communication technologies and respond to a demographic shift that has elevated Millennials to the top of the workforce food chain.
Younger workers are fine with higher employee density so long as their workplace is designed around their preference for flexibility and mobility. So, business owners have responded by buying into the creative space phenomenon that has reshaped the office environment over the past several years. Polished concrete floors, open ceilings and a conspicuous lack of private offices are now the new standards for tech and professional & business service companies that are fueling job growth in Orange County.
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Co-working Space as Disrupter
Many smaller companies have opted to locate in co-working spaces instead of committing to their own long term leases. Co-working space designs are consistent with those for creative space, so employers can recruit and retain younger workers without expensive long-term commitments for space they may outgrow in the short term.
While there are no hard statistics to measure the specific impact of employee density and competiti on from co-working spaces, most industry experts, including owners, property managers, asset managers and the brokerage community all agree that it is significant. In 2019, over 500,000 square feet has been leased by co-working operations. WeWork alone has leased six new Orange County locations totaling almost 379,000 square feet since the fourth quarter of 2018.
Since WeWork announced its intention to go public, turmoil within its ranks has been daily front-page news. So, it may be that the pioneer in the co-working world may not be a major contributor to Orange County's leasing activity going forward. To be sure, a failure of WeWork at the corporate level would have a profound impact on office markets across the US. The company has expanded so fast that it is now the largest office space occupier in New York City. Who would have believed that could happen to a company that came on the scene just nine years ago?
Vacancy Drifting Higher
Slower transaction volume and new inventory deliveries have combined to cause an increase in overall vacancy. That trend should continue into next year as the last of the major construction projects come online. The vacancy rate has risen by almost 200 basis points in the past three years to its current rate of 10.3%, and that is good cause for concern for owners of new projects looking to get their initial lease-up completed, and also for landlords whose space is not well-located or is lacking in amenities that will attract companies with younger employees.
Average Asking Lease Rates Still Moving Up
The good news for landlords is the fact that average asking lease rates are still moving higher. Orange County rents have increased by a modest 0.9% in the last 12 months. That increase is substantially driven by first-generation space that was either recently completed or is still under construction. New ground-up development is being built on very expensive land, and even at today’s lease rates, it is difficult for developers to achieve Pro-forma performance. Several recently completed projects are taking longer than expected to lease-up at their premium price point, and it’s taking some hefty concessions to attract larger tenants.
Coupon vs Effective Rate Gap Getting Bigger
Co-working operators are the largest new tenants in several major projects in the Airport and Irvine Spectrum submarkets. Though the coupon rate on these deals may be high and still moving up, concessions like free rent and over-standard tenant improvements are applying downward pressure on effective rates. While it is difficult to accurately track tenant concessions because of the proprietary nature of actual lease terms, industry insiders agree that landlords are becoming more inclined to offer them in return for higher coupon rates. So, even as asking rates inch higher, we expect the gap to effective rent to increase, especially if the slowdown in transaction velocity continues.
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Cautious Optimism for 2020
The Orange County office market is in generally good health and should remain so heading into 2020, barring some black swan economic event. Job growth for the region remains strong, and that means business owners, in general, are still optimistic about their prospects for growth. Construction activity is cooling off, which reduces the chance of excess supply if the overall economy does stumble. Despite the recent uptick in vacancy, supply and demand are in the relatively good balance heading into next year.
At the Kelemen Company, we are constantly working with our property owners, like yourself to ensure your properties are operating at peak efficiency no matter the market condition so that you can be worry-free. If you would like to learn more about how to keep your property optimized to take full advantage of market conditions, we are just a phone call away. We look forward to hearing from you.
The following sources were used in the preparation of this report:
Cushman & Wakefield Orange County Snapshot
JLL Orange County Insight
Voit Real Estate Services Orange County Office Market Report
CoStar Report
