Limited Office Construction in Triangle Area Bolsters Market Fundamentals

by John Nelson

The Raleigh-Durham office market has not only recovered from the Great Recession, it is solidly in expansion mode, and tenants are facing market conditions not witnessed in 15 years. The current cycle has been marked by a prolonged period of limited development activity. While job growth in the local market has been rebounding for more than five years, the construction pipeline has only recently filled in a meaningful way, and a large portion of the development activity in 2014 and early 2015 was driven by build-to-suits.

With Class A vacancy now at a 15-year low, speculative development is heating up again. While projects totaling 1.4 million square feet were underway in the first quarter, most of this product will not be delivered until 2017 or later, and approximately half of the space has already been spoken for.

Elizabeth Gates, Avison Young

Elizabeth Gates, Avison Young

In the near term, the market heavily favors landlords. The Triangle office market began 2016 with strong activity as tenants absorbed 453,997 square feet, driving vacancy down by 40 basis points to 12.1 percent. This figure is down by 180 basis points on a year-over-year basis and has fallen from a cyclical high of 18.7 percent. Class A vacancy ended the first quarter of 2016 at 9.3 percent, down by 130 basis points year-over-year and the lowest rate witnessed since the end of 2001. As a result, average asking rental rates have begun a steep upward climb. The average Class A asking rate ended the first quarter at $25.19, up by 5.4 percent year-over-year and a record high for the region.

The higher price point of new construction will only drive these rental rates higher as new space comes on line and owners of existing buildings increase rates to close the gap. The average asking rate per square foot for projects currently under construction is north of $31. Tenants facing renewal will, in many cases, be in for a rude awakening. The market is dramatically different than it was just a few years ago. As leases roll, budgetary concerns will likely lead some tenants to relocate to more affordable Class A or B space upon lease expiration.

Tenants are also faced with surging tenant improvement costs. In addition to the rising cost of materials, contractors are stretched thin following a downturn in which much of the day labor left the construction industry.

Seven of the Triangle’s 13 submarkets ended the first quarter with vacancy in the single digits. Downtown Durham in particular is facing a severe shortage of space with overall vacancy at just 2.9 percent and Class A vacancy at 1.4 percent. Vacancy remains elevated at 17.4 percent in Raleigh-Durham’s largest office submarket, I-40/Research Triangle Park (RTP), but a deeper look reveals the market for premium space in this corridor is actually quite tight. Vacancy in and around RTP has been inflated in recent years by older, in many cases functionally obsolete, legacy IBM space.

Class A vacancy in the submarket ended the first quarter at a healthy 10.4 percent, and Class A asking rental rates rose by 7 percent over the preceding 12-month period.
Significantly improved leasing fundamentals are driving strong investor interest in the Raleigh-Durham office market, particularly as pricing has become overheated in many first-tier markets. Office sales volume in the Raleigh-Durham region totaled $1.3 billion in 2015, an increase of 110 percent over the previous year. Nearly $500 million of that volume resulted from the sale of Duke Realty’s office portfolio.

Investment sales totaled $137 million in the first quarter of 2016, and several large assets are currently for sale or in the process of being taken to market as more owners sense the rising tide.

The only construction completion of the first quarter was in the North Hills development in the Six Forks Road submarket. The 313,655-square-foot Bank of America Tower was delivered 40 percent pre-leased to Bank of America and its subsidiaries, US Trust and Merrill Lynch. Three buildings broke ground in the first quarter. The 27-story mixed-use One City Center in downtown Durham will include 130,195 square feet of office space, 42 percent of which has been pre-leased to Duke University. The Dillon, a mixed-use redevelopment project in downtown Raleigh, will contain 210,000 square feet of office space, none of which has been reported as pre-leased.

Construction also began on Forty540, a 200,000-square-foot speculative office building in the I-40/RTP submarket. Additionally, announcements were made for two planned second-quarter starts, both of which are speculative. Highwoods Properties will break ground on 166,000 square feet at CentreGreen Three in Cary, and Heritage Properties will begin construction on the 129,000-square-foot Legacy at Brier Creek in the I-40/RTP submarket.

The pace at which vacancy is falling may slow in 2016 as new construction is delivered. Class A vacancy could even bump up slightly, but not enough to provide relief for tenants. Barring an unforeseen shock to the national economy, landlords should remain in the driver’s seat through at least 2017.

— By Elizabeth Gates, Principal and Senior Vice President of Research, Avison Young. This article originally appeared in the June 2016 issue of Southeast Real Estate Business.

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