The Raleigh-Durham region’s continued strong job growth is fueling sustained demand from tenants, keeping the office market firmly in favor of landlords despite a notable increase in construction activity in recent months. The region added 26,500 jobs between October 2017 and October 2018 for a growth rate of 3 percent. Unemployment fell from 3.8 percent to just 3.0 percent during this time, hitting its lowest level since 2000.
Despite not making the final cut for massive headquarters expansions from Amazon and Apple, Raleigh-Durham experienced significant economic development wins in 2018. Major job announcements came from office-using tenants such as Advance Auto Parts (435 jobs), Pendo (590 jobs), Arch Capital Services (365 jobs), Ipreo (250 jobs) and LabCorp (422 jobs).
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As in many markets across the United States, co-working operators significantly increased their presence in the region in 2018. Spaces has signed leases at five Raleigh-Durham properties, and WeWork committed to two locations and has stated that it plans to triple its local footprint in the near term.
In November 2018, Forbes ranked North Carolina the nation’s No. 1 state in which to do business, and Urban Land Institute and PricewaterhouseCoopers named Raleigh-Durham the No. 3 U.S. market in their Emerging Trends report to watch for overall real estate prospects in 2019. The region’s quality of life, robust population and job growth and highly educated workforce are supporting sustained business expansion and healthy leasing fundamentals.
Net absorption surged to more than 1.2 million square feet in 2018 as construction deliveries hit the market late in the year with substantial space preleased. Deliveries slightly outpaced absorption, but not by enough to dramatically impact vacancy. Market-wide vacancy stood at 12.7 percent in the fourth quarter of 2018, down 10 basis points year-over-year despite a wave of deliveries. Class A vacancy rose 40 basis points during this time but remained constrained at just 10.3 percent. Class B vacancy fell 110 basis points year-over-year to end the fourth quarter at 17.3 percent.
Approximately 1.6 million square feet of new space was delivered in 2018, with 65 percent of the space preleased upon completion. Developers have been active in both urban and suburban submarkets across the region, but the greatest concentrations of activity have been in downtown Durham, which has faced a severe shortage of Class A space in recent years, and in the I-40/RTP corridor, the region’s largest office submarket.
Projects totaling 2.1 million square feet were under construction at year-end 2018. Vacancy is likely to trend higher this year as much of this space is delivered, potentially giving tenants additional leverage in negotiating concessions. However, landlords are projected to maintain the upper hand in the near term. Approximately 55 percent of the space underway has already been reported as preleased.
Average asking rental rates remained on a steep upward trajectory throughout 2018. While tight market conditions and rising construction costs have been major factors in rising rates, a dramatic increase in investment sales played a particularly significant role in 2018. Owners pushed rates higher before taking buildings to market, and buyers typically increased rates again after closing and, in many instances, investing in improvements.
The average full-service Class A asking rate surged to a record high of $28.62 per square foot in 2018, up 8 percent year-over-year. A shortage of Class A options and rapidly escalating occupancy costs drove strong demand for Class B properties, sending the average Class B asking rate up by 9 percent to end the year at $21.38 per square foot.
Office investment sales activity took off like a rocket in 2018, fueled by strong leasing fundamentals, the ability to acquire properties below replacement cost and increasing interest from investors looking for more upside opportunity versus more expensive gateway markets.
Office sales volume surged to a record high of more than $1.9 billion in 2018, an increase of 71 percent versus 2017 volume. Sales activity was broad-based with interest strong for both urban and trophy assets, as well as suburban properties and value-add opportunities.
The Raleigh-Durham office market is poised for continued expansion in 2019, but the pace of absorption, investment activity and rent escalations will likely moderate. The maturity of the current cycle, rising interest rates and an incredibly tight labor market suggest that the market is likely at or near its peak.
Unlike previous cycles, however, lenders and developers have been disciplined, and over-supply is not currently a major concern. Construction costs continue to be a challenge for both landlords and tenants, driving both rent rates and tenant improvement expenses dramatically higher. The resulting sticker shock has contributed to a protracted lease negotiation cycle, a trend that is likely to continue in the near term.
While the addition of new space to the market is at last providing office users with much-needed new options, competition for prime locations remains fierce, and tenants must act decisively or risk losing out on their desired space.
Elizabeth Gates is a principal and senior vice president of research for Avison Young. This article originally appeared in the January issue of Southeast Real Estate Business.