Triangle’s Office Vacancy is up Due to New Supply, but Job Growth is in a Good Spot
The Raleigh-Durham region’s 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. According to the Bureau of Labor Statistics, the region added 24,200 nonfarm payroll jobs between October 2018 and October 2019 for a growth rate of 2.5 percent. Unemployment rose slightly from 3 percent to just 3.1 percent during this time as nearly 36,000 people entered the local labor force.
Raleigh-Durham continued to witness economic development wins in 2019 as well. Major job announcements came from office-using tenants such as Xerox (600 jobs), Q2 Solutions (700 jobs), Parexel (260 jobs), AmeriHealth Caritas (300 jobs) and HZO (500 jobs).
In its recently published Emerging Trends in Real Estate report, the Urban Land Institute and PricewaterhouseCoopers (PwC) named Raleigh-Durham as the No. 2 market in the United States to watch for overall real estate prospects in 2020. The region’s quality of life, robust population and job growth and highly educated workforce are supporting sustained business expansion and healthy leasing fundamentals across all asset classes.
Raleigh-Durham’s office market continues to experience the most landlord-favorable conditions since the dot-com boom in the late 1990s. Trailing 12-month net absorption totaled more than 1.7 million square feet as of third-quarter 2019, slightly lower than the 2 million square feet in construction deliveries witnessed during this time.
Market-wide office vacancy rose 60 basis points year-over-year to end the quarter at 12.6 percent. Class A vacancy remained incredibly tight at just 10.1 percent in the third quarter, but the addition of new product to the market at last gave tenants much-needed leasing options. Class A vacancy stood at just 8.7 percent one year earlier.
Meanwhile, rental rates are escalating at a torrid pace. The average Class A asking rate rose to $29.89 per square foot in the third quarter, up 9 percent year-over-year and 27 percent in the past five years. After breaking the $40 barrier for the first time in early 2019, the Triangle ended the third quarter with three office buildings posting asking rates of $41 per square foot or higher. Rapidly escalating rental rates are not entirely due to tight market conditions.
The biggest pain point for both landlords and tenants continues to be soaring tenant improvement costs and delayed construction timelines, both driven primarily by a shortage of skilled labor. Tenants are signing longer leases and settling for higher contract rental rates and fewer concessions in exchange for hefty tenant improvement packages. A frothy investment sales market is also a contributor to rising rates. Owners are pushing rates higher before taking buildings to market, and buyers typically increase rates again after closing and, in many instances, investing in improvements.
Following record-setting office sales volume of $2.1 billion in 2018, investor demand for Raleigh-Durham office assets remains intense. Trailing 12-month sales volume totaled $1.2 billion in the third quarter. The sale of the Captrust Tower at North Hills set a new per-square-foot pricing record for the local office market. Preferred Office Properties paid $137.8 million (or $459 per square foot) for the 300,000-square-foot, 16-story tower.
Office buildings totaling 2.5 million square feet were under construction with 31 percent of the space reported as preleased. Construction deliveries are likely to push office vacancy slightly higher in 2020, but not enough to move the needle significantly in favor of tenants. Development activity is thus far in line with demand, keeping concerns of overbuilding at bay. Soaring construction costs and tight market conditions will keep upward pressure on rental rates, although the pace of growth may moderate.
While the region’s CBDs will continue to attract tenants and developers, the suburbs will also perform well as creative office space and mixed-use environments spread beyond the urban core. Some of the region’s aging commercial properties present excellent opportunities for reimagined space and placemaking. For example, in the I-40/RTP submarket, developers have recently announced plans to convert a long-vacant outlet mall and a former Nortel manufacturing facility into creative office environments with activated indoor and outdoor common areas.
The uncertainty inherent in a presidential election year, combined with a late economic cycle, may lead to a modest slowdown in leasing and investment activity in 2020. Nonetheless, the overall outlook remains positive as local economic fundamentals are sound and discipline on the part of lenders and developers should help the market avoid the hyper-supply witnessed in the latter stages of previous cycles. Amid stock market volatility and declining global growth, Raleigh-Durham’s expanding — and relatively affordable — real estate market offers an attractive destination for abundant capital seeking yield.
— By Elizabeth Gates, Senior Vice President of Research at Avison Young. This article originally appeared in the January 2020 issue of Southeast Real Estate Business.