Myriad Factors Help Explain Why Kansas City Office Market Has Not Reached Full Altitude
The Kansas City office market is poised for increasing rental rates and decreasing vacancy rates for the remainder of 2017 and into 2018. Kansas City has realized its 14th consecutive quarter of increased rental rates (through March 2017), while vacancy has decreased in the overall metro area due to lack of new office construction and a steady pace of absorption.
Several factors contribute to the complexity of why the market is good but not great, steady but not dynamic, with no one factor driving the steady upward climb. It has been like a plane taking off but never reaching full altitude. A contradiction of sorts is contributing to the rental rate increases and vacancy decline, while there is still a lack of newly constructed space.
Bread-and-butter leasing absorption and a lack of new speculative development have been the main ingredients in the overall solid market for office activity. The velocity in the market is doing its job of generating positive absorption each quarter while rates inch up. The lack of large blocks of space has created a few new construction projects, but not as many as experts had predicted and hoped for.
Costs on the rise
Higher construction costs and hesitancy from tenants to commit have slowed expectations about speculative or partial spec projects. While there have been several large leases that have plugged big vacancies and are spurring new office and mixed-use developments, there are just not enough to push Kansas City’s office market into generating a perfect scenario for reaching the altitude it needs for spec development.
The combination of extremely hot apartment and industrial development markets, redevelopment in the urban core and local public projects are siphoning off laborers. These are largely the contributing factors to the hike in costs.
Merely the increased activity in construction among competing property types has driven tenant finish and office construction costs to new heights, which are driving rates to increase and terms to lengthen. Rental rates should increase when there is robust activity; however, there are other market factors moderating the rent increases and therefore creating the disappointment about no spike in spec development.
New spec projects are what make the market sustain increased rates, but without them the required increases will not be enough to justify new construction on its own. Big announcements include: Cerner’s Three Trails project of 4.7 million square feet unveiled in 2015; Select Quote going to Overland Park Xchange; Mariner and Teva at Nall Corporate Centre; Creative Planning going to I-435 and Nall; Teva spurring the redevelopment of Fitness Plus More at 4500 W. 107th St.; KU leasing 60,000 square feet at Corporate Avenue in Southlake; and Kiewit being in the market for 400,000 square feet.
All this activity sounds robust, but it did not create speculative development for third-party leases to help push up rates except for 40,000 square feet at Nall Corporate Center.
When Sprint releases 250,000 square feet into the market and companies like Cerner, Fishnet and Creative Planning contain their appetite for space in single-tenant projects, it may help push up rates through construction pressure.
But these decisions temper the general market for setting up the perfect scenario for new office spec construction. These projects do not supply the market with new high-quality space and offer third-party tenants a chance to pay higher rental rates, thus allowing the market to take off with gusto. These higher rates are required for both spec development and for building sales to achieve expected cap rates.
Tower Properties’ 6601 College Boulevard renovation in an A+ location with new skin and a new image took 24 months to lease at rates in the high $20s. Generally, Sprint can offer 20,000 to 50,000 square feet at $20.50 with plug-and-play furnishings and tenants only paying electricity.
These rent differentials make complete renovations and new construction hard to justify, requiring between $28 and $30 per square foot unless a tenant is signed up. The corporate user must step up like Mariner did to lease Nall Corporate Center II, a partial spec building.
The moderating of new spec development by high construction costs, Sprint’s additional space on the market, active but tentative tenants with some sticker shock and conversely the hike in rates when projects do occur, is a complex formula. This results in gradual upward pressure on rates and falling vacancies, but it is not enough to spur new spec offerings and much significant redevelopment.
What will it take for the Kansas City office market to get gusto and take off like Denver, Austin and Nashville markets? First, look at the historical perspective. The nation’s confidence from the uncertainty of an election year in 2016 has not yet had a full recovery. The instability of the government’s legislative agenda contributes to providing uncertainty while the economy continues to grow steadily.
Office users are still experiencing densification and movement to the urban core, in some cases leaving the suburbs. The millennials are driving this move though their desire to live in the core, and companies are following to attract knowledge-based workers that are becoming in short supply.
Some companies have become the catalyst for new urban redevelopment. Hollis and Miller Architects and Holmes Murphy both leased in downtown’s Corrigan Station. New mixed-use nodes of development, like Lenexa City Center at 87th Street Parkway and I-435, offer build-to-suit sites for large users.
The perfect scenario will require a stabilization of government initiatives, continued low interest rates, less pressure on construction costs, attracting knowledge-based workers so companies can expand, and lessening the gap between existing and new construction rental rates. The investor needs to see the potential for upside in his acquisitions.
The disconnect between buyers and sellers was apparent in 2016 when three portfolios — Corporate Woods, South Creek and Southlake — were offered for sale but did not trade. The portfolios all required the projection of significant rate increases, so meager upside hindered these sales. There are various Class B buildings that are virtually 100 percent leased on the market that have not sold during this cooling off of the capital markets.
So, Kansas City needs a change in altitude, and maybe attitude, to spur new interest in these properties and for spec development to reach new heights.
— By Debora Field, Managing Director, and Susan Smith, Managing Director and Principal, Newmark Grubb Zimmer. This article first appeared in the September 2017 issue of Heartland Real Estate Business magazine.