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Tenants Gain Leverage in Raleigh-Durham Office Market as Supply Comes On Line

The 27-story One City Center in downtown Durham will feature retail space, residential units and 130,000 square feet of office space.

Eight years into the recovery, Raleigh-Durham’s office market conditions remain decidedly in favor of landlords, but increased construction following years of limited development activity is at last providing much needed new leasing opportunities for tenants.

While a combination of factors, including new construction, drove office vacancy higher by the second half of 2017, the market began the year with the tightest Class A leasing market witnessed since the dot-com boom. Class A vacancy bottomed out in the first quarter of 2017 at 9.1 percent, down from a cyclical peak of 17.6 percent in the third quarter of 2009, and the lowest level since fourth-quarter 2000.

Elizabeth Gates, Avison Young

Elizabeth Gates, Avison Young

Class A vacancy rose to 11 percent in the third quarter of 2017 as a wave of new deliveries hit the market. Total vacancy ended the third quarter at 13.5 percent, up 70 basis points year-over-year. It is worth noting that this figure includes a handful of large, formerly corporate-owned facilities in the Interstate 40/Research Triangle Park (RTP) submarket.

Originally constructed for single tenants such as GlaxoSmithKline, Dupont and Reichold, these facilities are likely to need substantial retrofitting to achieve lease-up. While they are certainly a factor in the market, they are not an option for the typical Raleigh-Durham end user and will likely keep vacancy elevated in the near term. When these properties are factored out of the market’s inventory, vacancy stands much lower at just 9.6 percent.

Tight leasing conditions have driven strong rent appreciation in recent years. The average asking rental rate stood at a record-high of $23.84 per square foot in the third quarter, up 7 percent in the last 12 months and 23 percent in the last five years. Infused with confidence, developers have begun to fill the construction pipeline again. The surge in construction activity that began in 2016 drove the square footage underway to its highest level since the Great Recession.

Nonetheless, both lenders and developers are exercising restraint, and activity remains modest by historical standards. The 1.8 million square feet underway at the end of the third quarter of 2017 represents approximately 4 percent of inventory. Square footage underway in previous cycles peaked at more than twice that level.

The region’s largest lease transactions in 2017 were dominated by preleases, demonstrating the need for additional large blocks of high-quality space on the ground. Approximately 48 percent of the space underway has already been preleased, and several large leases have been signed for proposed projects that have not yet broken ground. Projects totaling 1.4 million square feet were delivered in the first three quarters of 2017 with 63 percent of the space reported as preleased.

While the addition of new product has pushed vacancy slightly higher, overbuilding has not become a major concern. Developers have been most active in the downtown Durham, downtown Raleigh, I-40/RTP, West Raleigh, Six Forks Road and Cary submarkets. In the I-40/RTP corridor, the region’s largest office submarket, completions totaled 644,000 square feet in the first three quarters of 2017, and another 408,000 square feet of space remained underway.

In supply-constrained downtown Durham, where vacancy has fallen as low as 2 percent in recent quarters, several projects are making their way through the development pipeline. The 284,000-square-foot, adaptive reuse Chesterfield project was completed in 2017, and another 642,000 square feet is scheduled for delivery this year. The 27-story One City Center, featuring retail space, residential units and 130,000 square feet of office space, will give Durham its first new high-rise development in nearly three decades.

Rising asking rates have not only driven an increase in new construction; they have also given owners of older buildings the incentive to invest in substantial property improvements, including common-area upgrades, building system improvements and the addition of new amenities such as fitness centers, shared conference facilities and cafés. This trend is expected to remain prevalent in 2018 as more properties trade and investors increasingly seek out value-add opportunities.

While investment sales activity slowed nationwide in 2017, the Raleigh-Durham region continues to experience robust demand as investors increasingly turn their focus to more affordable secondary markets. Office sales volume totaled $698 million in the first three quarters of 2017, up 14 percent versus the same period in 2016.

Overall, conditions are likely to remain in favor of landlords over the next 12 months, but upward pressure on vacancy rates should provide tenants with a bit more leverage in 2018. Asking rental rates are not expected to soften in the near term, but the rate of increase is likely to moderate, and concessions may become more prevalent as increased deliveries provide more options for tenants.

Robust job growth is expected to fuel sustained leasing activity, keeping supply and demand in relative balance as new construction continues at a measured pace. Raleigh-Durham has enjoyed a flurry of economic development wins in recent months, thanks in part to the repeal of North Carolina’s controversial House Bill 2.

Among the most recent announcements, Infosys chose the region for a technology hub that will add 2,000 jobs, Credit Suisse announced a 1,200-job expansion, INC Research announced a 550-job expansion and MetLife committed to a third building at its recently constructed, 427,000-square-foot campus. The region’s job growth measured in at a healthy 3 percent in the 12 months ending October 2017, and unemployment fell from 4.3 percent to 3.6 percent during the same period.

— By Elizabeth Gates, Principal, Senior Vice President of Research, Avison Young. This article originally appeared in the January 2018 issue of Southeast Real Estate Business.

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