Surge in New Office Supply Reshaping Downtown Skylines

U.S. Office Construction Ramping To Meet Tenant Demand for High-Quality CBD Space

Rising demand from top corporate tenants for a shrinking supply of high-quality office space is fueling another wave of skyline-altering office development in U.S. CBDs and inner-ring suburbs.

For a prime example, look no further than the 40-story, 662,000-square-foot skyscraper Hines Interests started last month at 1144 15th Street. The tallest office tower to be built in Denver since the 1980s, the Pickard Chilton-designed building is due for delivery in early 2018 and is being built completely on spec with no prelease commitments, a major vote of confidence in a market that has declining vacancy and an 8.2% increase in CBD rental rates so far in 2015.

About 70% of the new office space underway in Denver is located within the CBD, with 25% of that space already preleased, according to DTZ's Denver office.

"Most vacant office buildings in Denver are primarily made up of second-generation space under 100,000 square feet, not big enough to entice companies who are contemplating moving their business to Denver," said Andrea Jones, vice president marketing and research for DTZ. "There are only 10 buildings offering 100,000 square feet of contiguous vacant space and only three of those buildings are in the CBD."

Denver is among 10 of the largest U.S. metros where increasing rents and high tenant demand for quality space has prompted office developers to open the construction pipeline. After several years of very low supply growth, in-process office construction reached 124 million square feet in the second quarter of 2015, the highest since early 2009, according to CoStar data.

Although demand is beginning to stir in suburban office markets as well, tenant interest appears to remain focused on CBD space in particular. So much so that demand is spreading from the highest quality buildings into the Class B space, DTZ Chief Economist Kevin Thorpe said.

"Downtown areas in most U.S. cities are thriving right now, which is pushing rental rates up not only for high-quality Class A space but across the board," said Thorpe. "Suburban office is still muddling through in most places, but tenant demand in almost every CBD in the U.S. is as robust as anything we have observed since the late 1990s."

Although the amount of office space taken by tenants still exceeds the amount of new space being developed, the gap is narrowing. Office delivery volume has risen to 61% of total net absorption over the last four quarters, up from 52% in the second quarter of 2013, according to DTZ's second-quarter office trends report.

And while all the new inventory will likely impact vacancy and rent growth by 2018, for now the U.S. office market is enjoying a rare moment of supply-demand balance, according to CoStar analysts.

And it appears the office market has a lot of open runway ahead of it. Office construction levels are still below historic averages in most markets. New supply isn't expected to exceed net absorption rates until 2017, with falling vacancy rates flattening in 2018.

"For the first time since the recovery began, we're now seeing a return to historical average construction," said Aaron Jodka, senior manager, analytics for CoStar Portfolio Strategy.

The most recent U.S. office construction trends reflect the growing number of younger workers seeking to live and work in urban cores. In 2000, just 20% of office construction projects where in the CBD. Today, that number has risen to 40.2%.

In Portland, for example, demand for the limited supply of high-quality space by tech companies is driving more than 1 million square feet of office construction, the most since 2009.

This year, Google joined the trend by opening offices in the CBD, further boosting Portland’s appeal across the country as a tech headquarters, says Mark Porter, Portland market analyst for Colliers International.

"Tech accounted for more than 26% of CBD leasing activity in 2014, with the trend continuing for the first half of 2015," Porter said. "Two-thirds of the leasing activity in the second quarter for 10,000 square feet of space or more was in the CBD, and two-thirds of those transactions were for Class A space."

About 90% of Portland's new office space will hit the market in the first half of 2016, including nearly 467,000 in three buildings — Park Avenue West, Pearl West, and Block 8L — with nearly 50% in the CBD. About two-thirds of the space is already pre-leased.

Big corporate expansions are also triggering office development in Minneapolis, where new inventory is approaching pre-recession levels with 3.1 million square feet of office space under way and more than 10 million square feet in the pipeline.

United Healthcare, Wells Fargo and Cardiovascular Systems are among the companies moving into new buildings this year, and the first of two towers for Wells Fargo, the largest speculative
office building to be delivered in a number of years, will provide significant new supply in the redeveloping Downtown East neighborhood next to the new Vikings stadium, according to Marcus & Millichap.

Competition for tenants will intensify as these firms vacate leased space throughout the metro and move into their new quarters.

Tenant dislocation as new supply is coming on line is also a concern in Denver, albeit for a different reason. The Mile High City's CBD has seen some downsizing and increasing of sublease space by energy companies, which have become vulnerable with the fall in oil prices.

In Denver's CBD, where 98% of the office inventory is at least 20 years old, tenants may flock to 1144 15th Street and other new trophy in the vicinity of Union Station as the development pipeline balloons rapidly, leaving lesser-quality space to backfill.

In addition to Denver and Minneapolis, markets with large blocks of space under construction include San Jose, CA; Houston, Nashville, Seattle and San Francisco, each of which has building activity exceeding 3% of their total inventory.

"The new supply in the second half of 2015, and through 2016 and even into 2017, which will present opportunities for occupiers to continue to expand and help to temper rent, which will also allow occupiers to expand," added Julia Georgules, director of office research for JLL.

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