Office Tenants are Small, Subleases are Big in Phoenix

by Jeff Shaw

— By Andrew Cheney, Principal, Lee & Associates —

The metro Phoenix office market continues a slow recovery as it battles the nation’s highest rates of both sublease growth and inflation.

Starting off the fourth quarter at only 532,000 square feet (year-to-date), net absorption in Greater Phoenix remained well off the 20-year average mark of 1.6 million square feet. Direct office vacancy stands at a seemingly high figure of 17.6 percent. However, this is in line with the 20-year average of 18 percent. 

Currently, there are six key trends impacting Phoenix’s office market.

Andrew Cheney, Principal, Lee & Associates

Small tenants are back in the office. 

I imagine most brokers will report that the highest concentration of active, touring prospects are in the market for less than 10,000 square feet.  These company sizes want to be in the office in metro Phoenix, and not just a few days a week.

High-quality spec suites rule. 

Landlords recognize that smaller tenants are driving leasing activity — and that these small tenants will not wait for a build-out. Instead of holding one or two spec suites in inventory at any one time, landlords are building out large batches of five to seven spec suites at a time. And they’re spending money to build them right. In return, these suites are leasing and exceeding pro forma rates.

Construction pricing at peak levels. 

Combine inflationary pressures, a successful local economy and construction trades that cannot keep up, and the result is tenant improvement pricing that has reached all-time highs. The shell build-out that used to cost $60 per square foot three years ago now runs $90 to $100 per square foot to build out. Tenants and landlords are spending considerable amounts of time solving pricing problems that neither party has experienced in the past.

Lease rates are still rising where tenants want to be. 

Rents have climbed for trophy office buildings that are armed to help a company win talent. RED Development’s the Grove proved this in the Camelback Corridor submarket. At SkySong, the ASU Scottsdale Innovation Center, office tenants have valued a mixed-use campus and connection to the nation’s largest university. In most other office scenarios, the construction pricing problem has simply forced rents to hold or slightly increase. 

Sublease inventory rising at the highest rate in the nation. 

Phoenix does not hold the highest total inventory of sublease space. However, according to Costar, its 424 percent increase ranks as the biggest gain of sublease space that any major U.S. metro has experienced since third-quarter 2019. This inventory — 6.1 percent of the market — will gradually become direct space over several years. 

New office construction has slowed. 

These market dynamics — and the lack of large tenants willing to make the leasing commitments necessary to kick off new buildings — have significantly decreased new development. Metro Phoenix typically delivers 2.2 million square feet annually, which is added to its 105-million-square-foot base. There are currently 732,000 square feet under construction, which represents one-third of the 20-year average. 

Metro Phoenix boasts a diverse economy, a business- friendly climate and an incredible quality of life. The office market will recover and add exciting new developments to its supply…it just needs medium and large companies to figure out their return to the office. 

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