PART E. OFFICE MARKET ANALYSIS CHAPTER 14 THE MARKET FOR OFFICE SPACE INTRODUCTION OFFICE MARKET IDIOSYNCRACIES AND DETERMINANTS OF PROJECT SUCCESS OFFICE MARKET FUNDAMENTALS OFFICE SPACE DEMAND AND PROSPECTS Office-Using Sectors On Net Absorption and its Determinants THE SUPPLY OF OFFICE SPACE Income-Related Factors Cost-Related Factors and Availability of Capital OVERVIEW OF OFFICE MARKET ANALYSIS CHAPTER SUMMARY QUESTIONS REFERENCES AND ADDITIONAL READINGS INTRODUCTION This is the first chapter of Part E, which focuses on the analysis of commercial office markets. The purpose of this chapter is to first discuss the idiosyncrasies and economic fundamentals of office markets and then provide an overview of the major steps involved in analyzing them. Within this context, we first discuss the determinants of office project success within the context of the idiosyncrasies characterizing the marketplace for office space and, especially, its cyclical nature. We then elaborate on the demand and supply fundamentals of such a marketplace. On the demand side, the discussion focuses on the nature of the office-using employment sectors and the major determinants of demand for office space. On the supply side, the discussion focuses on the determinants of office construction investment, and, specifically on income-related factors, cost-related factors, and the availability of capital. We conclude the chapter with a brief overview of the market analysis process, as an introduction to Chapters 15 and 16. These two chapters elaborate on - 382 -
the macroeconomic and microeconomic aspects of market research, as they pertain to office development projects. OFFICE MARKET IDIOSYNCRACIES AND DETERMINANTS OF PROJECT SUCCESS Completing an analysis for office real estate development requires a thorough understanding of the idiosyncratic nature of office markets and the factors that affect the value and profitability of office properties at the intrametropolitan level. Given the idiosyncrasies characterizing the market for office space, the major determinants of office project success are the following: Timing Location Project Design Timing is a very important determinant of office project success because the office market is characterized by wide fluctuations in both (marginal) demand and supply and, as such, it is highly cyclical. The high cyclicality of the office space market is evident in Figure 14.1, which portrays the time path of the national vacancy rate over the period 1960-1999. 73 As the figure shows, during the 1970s the national office vacancy rate increased from 4% to almost 15% and then returned back to 4% by the end of the decade. During the 1980s, the office vacancy rate climbed to new highs, and by the end of the decade, it was hovering around 17%. The economic recession of the early 1990 s not only pushed it even higher up to 19%, but also triggered the collapse of property values. As a result, a dramatic decrease in the construction of new office space helped the national vacancy rate to gradually decrease below 10% by 1999. Figure 14.1 The Office Vacancy Cycle 20 15 10 5 0 1997.3 1993.4 1990.1 1986.2 1982.3 1978.4 1975.1 1971.2 1967.3 1963.4 1960.1 Source: CB Richard Ellis/Torto Wheaton Research 73 The vacancy rate portrayed in this figure represents the weighted average of 31 office markets covered by Torto Wheaton Research. - 383 -
Wheaton (1987) showed that the office market is characterized by prolonged endogenous cycles with long periodicity (6-10 years) and great amplitude (see Figure 14.2 for the definition of periodicity and amplitude). These cycles are generated by the synergy of the following demand, supply, and rent adjustment factors underscoring the inefficiency of the commercial office market: Repeated and unexpected office demand shocks triggered by changes in the national and local economies Sluggish demand, vacancy, and rent adjustments due to informational lags and inefficiencies, high adjustment costs, and long-term lease structures Sluggish supply adjustments, due to informational inefficiencies, investment-decision lags, and inherently-long construction lags Highly price elastic new supply, due in part, to myopic expectations on the part of real estate investors (which reinforce and amplify the effect of exogenous shocks), and the 74, 75 lumpiness of investments in new office structures Asymmetric stock adjustments in response to favorable vs. unfavorable exogenous demand shocks, in the sense that there is a ceiling to rent and price increases in response to positive demand shocks due to competition and supply responses, but downward rent movements are not constrained. 76 Figure 14.2 Cycle Attributes Peak Periodicity Amplitude Trough Location is the second important factor for office project success because of the role productive amenities valued by office tenants, and worker (non-productive) amenities valued 74 There is evidence that in the recent years the majority of office construction is directed towards the suburbs and as a result the average office investment is becoming less lumpy. 75 This conclusion is based primarily on office supply behavior during the 1980s. There is indirect evidence that, after the collapse of the real estate market in the early 1990s, investors and capital providers have been approaching real estate, and specifically office development projects, with greater caution compared to the 1980s (Sivitanidou and Sivitanides, 2000). If this is in fact the case, office consctruction may be becoming less price elastic. In addition, there is discussion in the industry of the increasing role public markets may be playing in the real estate market and their potential contribution in reducing its volatility through their forwardlooking approach and analytical discipline. 76 See Sivitanidou and Sivitanides (2000). - 384 -
by their employees, play in determining firm costs (labor costs, rent, etc.). Since such amenities may not be uniformly distributed within a metropolitan area, location selection can help office firms minimize such costs. In addition, because of linkages among office activities, intrametropolitan location selection may also play a role in affecting office firm costs and revenues. Project design is thought to be less important than timing and location, but still the choice of the appropriate development density can be very crucial in maximizing residual land values. OFFICE MARKET FUNDAMENTALS OFFICE SPACE DEMAND AND PROSPECTS Office space is a required production input by firms within several SIC-code classifications, justifiably referred to as office-using sectors. The amount of space per worker required by a firm depends on the nature of its operations and expected growth. Furthermore, a firm s realized demand for office space in the marketplace should be conditioned by prevailing lease rates. Therefore, market demand for office space is determined primarily by four major factors: 1) office employment 2) space-per-employee requirements 3) rental rates 4) expectations Sivitanidou (2002) has provided indirect evidence of the effect of three of these four factors on office space demand in a panel study of office rent differentials across the nation s major office markets. In particular, this analyst has demonstrated that office employment levels, office employment growth rates --most likely capturing growth expectations-- and the ratio of FIRE to total office employment --reflecting the higher space-per-employee requirements in this sector-- have positive and statistically significant influences on metrowide office rent levels. Such effects are consistent with the expected influence of these factors on the demand for office space. It should be noted that Sivitanidou (2002) provides also indirect evidence of differences in office space demand levels across markets attributable to some additional factors affecting tenant search processes. These additional factors include the diversity of the local office tenant base, and the spatial/nodal distribution of the local office space stock. In theory, such local market attributes affect absorption through their effect on the matching probability between tenants and landlords and on search costs. Given that such attributes change slowly through time, these factors are more relevant in understanding differences in office demand levels across markets, as opposed to changes in office demand through time within the same market. Within this context, accurate assessment and forecasting of office space demand prospects in any market requires an understanding of how the basic forces that drive its movements through time are likely to unfold over the project s planning horizon. - 385 -
Office-Using Sectors Studies by Torto Wheaton Research suggest that the two major office-using sectors of the economy are Finance, Insurance, and Real Estate (FIRE), and Services (including primarily Professional Services, Business Services and Government). Estimates show that 100% of FIRE workers and about 36% of Service workers are office space users and that these two sectors account for about 80% of total office employment, with the remaining 20% accounted for by the industrial sector (Wheaton, 1987). According to DiPasquale and Wheaton (1996), the Service subsectors that can be considered as office-using include Advertising, Computer and Data Processing, Credit Reporting, Mailing and Reproduction, Legal and Social Services, Membership Organizations, and Engineering and Management Services. Carn et al. (1988) present a different analysis that points to a somewhat lower contribution of FIRE and Services to total office employment. In particular, these authors distinguish between office-using and non-office-using occupations using 1980 Census data on the occupational composition of the different sectors. Their analysis concludes that 67% of employees in the FIRE sector and 28% of employees in the Service sector are office space users. Their analysis suggests also that some non-negligible shares of employees in the other one-digit SIC sectors ranging between 16% and 38% may also be users of office space. On Net Absorption and its Determinants Absorption of office space at the margin, or net absorption, should depend heavily on the extent of increases in office employment, as well as the other three major factors driving the demand for office space, that is, space per employee requirements, office rents, and growth expectations. Each of these factors is discussed below. Office Employment Growth The national office market has seen phenomenal office employment growth rates (5%-6% annually) in the late seventies and early eighties, which are unlikely to be repeated in the foreseeable future. Looking ahead, office employment growth rates are expected to be lower ranging between 2 and 3% for the following reasons: LFP rates are expected to be lower since the entry of baby boomers in the labor force has been completed and LFP rates by women have slowed down Immigration is expected to slow down as well The use of technology by office firms is expected to intensify, leading, perhaps, to a lower usage of the labor factor Space-per-Worker Requirements Space requirements per office worker vary by industry. For example, it is often argued that such requirements are higher in the prestigious FIRE sector as opposed to Services. Sivitanidou (2002) provides indirect evidence that is consistent with the premise that higher shares of FIRE workers in total office employment are associated with higher office space - 386 -
demand. 77 Carn et al. (1988) suggest that space-per-worker requirements vary also by occupation, with managers and professionals occupying more square feet, and clerks and secretaries less. Therefore, it is only appropriate to assume that average square feet requirements across metropolitan markets must vary given differences in sectoral employment composition and occupational structure. As Figure 14.3 indicates, space requirements per office worker followed basically an upward trend in the 1980s, but turned downwards in 1992 and kept declining until the end of the decade. 78 If this trend continues, it will contain demand for office space in the coming years. Does the downward trend that prevailed during most of the 1990s represent a secular trend, or will the market return to the tendencies of the 1980s, when occupied space per employee kept increasing? There are two potential interpretations: 79 A Secular Trend? The steady decline of square feet per employee may reflect the effect of several secular trends. These may include increasing sensitivity of office firms to cost considerations because of an increasingly competitive global environment; higher productivity due to technological improvements that may be reducing space per worker requirements; and increasing telecommuting arrangements between office firms and their employees. If there is indeed a secular trend of declining square feet per employee, office demand in the coming years will not be helped. Of course, it must be noted that square feet per employee can not decrease below the level required to accommodate a minimum acceptable level of space functionality. A Temporary Trend? A second interpretation of the decreasing office space requirements per employee in the 1990s is that it reflects only a temporary trend, brought about (at least in part) by rising real office rents during that period. DiPasquale and Wheaton (1996) have presented indirect evidence suggesting that, for given office employment levels, office space absorption, and therefore, square feet per employee, vary inversely with rental rates. 80 If this is the case then the average square feet per employee may begin rising again if real rents start declining. 77 Sivitanidou (2002) in an analysis of office rent differentials across the nation s largest office markets finds that for given office employment levels the ratio of FIRE employees to total office employment has a positive and statistically significant effect. One obvious rationalization of such influence is the higher space-per-worker requirements in the FIRE sector and its positive effect on office space demand. See the paper for alternative explanations of this effect. 78 The office employment figure used for this calculation was derived by adding up total employment in FIRE and selected 3-digit SIC service sectors. 79 The comments that follow have been added by the editor. 80 Due to the lack of sufficiently long historical series DiPasquale and Wheaton (1996) used lagged values of office vacancy as a substitute for rental rate levels in the absorption equation. - 387 -
Figure 14.3 Office Market Trends: Square Feet/Employee 220 35 215 32 210 29 205 26 200 23 195 20 190 17 185 14 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 Square Feet/ Employee Real Rent Source: CB Richard Ellis /Torto Wheaton Research Office Space Rents As the fundamental law of demand postulates, all else being equal, increasing office rents should exert downward pressure on office space absorption, while decreasing rates are expected to influence positively office space demand. The potential influence of rental rates on space-per-employee requirements is very important because it has significant analytical implications that cast doubts on the accuracy of a very commonly used technique for forecasting office space demand (see discussion in the next chapter). Expectations We can distinguish two types of expectations that may influence demand for office space at any given period: rent growth expectations and employment growth expectations. Rent growth expectations may have a positive effect on net absorption, since firms may be motivated to lease space at the present than wait later, in anticipation of rent increases in the future. Such expectations are very likely to prevail within a tight market environment where rental rates have already started rising. Office employment growth expectations can also have a positive effect on office space absorption, as firms are likely to lease more space than they currently need in anticipation of their expanding workforce. Since relatively slow employment growth is expected in the future, growth expectations may not have a significant effect on net absorption of office space. - 388 -
THE SUPPLY OF OFFICE SPACE Since office projects take usually about two years to complete from the time of inception and one to two years for lease-up, office market studies aiming at guiding investment and development decisions need to have a three- to four-year planning horizon at minimum. Simple counts of projects permitted and under construction can provide little clues, if any, about the levels of available supply three to four years ahead of the time of analysis. For this reason, it is very important to examine past trends and evaluate future prospects in the factors that drive office construction investments at the macro analysis level. Since profitability is the prime motivation of office development, these factors include the determinants of the income-earning capacity of an office property, the perceived risk of expected income flows, and development costs. Income-Related Factors Factors pertaining to an office building s income-earning prospects that may influence construction investment include the following: Rents Increasing rents are likely to boost development only to the extent they rise (or are expected to rise) to or above the levels that would justify new construction. In particular, office rental rates must rise to a level for which the implied asset price would be greater than development costs in order to trigger new construction. 81 The experience of the 1980s has shown the supply of office space to be highly price/rent elastic, but the experience of the 1990s points to a more disciplined behavior. Vacancy Rates As indicated earlier, office vacancy rates fluctuate considerably through time, thereby inducing significant fluctuations in a property s rental income. During periods with sufficiently low vacancy rates and, therefore, higher property income, investors may be motivated to provide capital for new office development projects. In this sense, markets with lower vacancy rates maybe facing prospects for higher levels of new office space additions in the future. Expectations Myopic supplier expectations for improving market conditions due to improving demand indicators, such as office employment growth and declining vacancy rates, may also contribute to greater office construction levels. Office space completions are thought to largely be driven by such expectations. Market Volatility and Risk Higher employment volatility in office-using sectors, such as, FIRE and Services, may discourage new construction investments, as it may signal a greater demand uncertainty and development risk and, as such, raise the level above 81 The reader is reminded that property value or asset price and rental rates are linked through the income capitalization formula, which postulates that value is the ratio of the property s NOI over the market capitalization rate. Sivitanidou and Sivitanides (1999) have shown that office market capitalization rates are driven by factors that shape income growth expectations and risk perceptions, as well as interest rates. - 389 -
which rents must rise to justify new construction. Historical data reveal that FIRE employment is much more volatile than employment in Services. A recent study by Sivitanidou and Sivitanides (2000) provides evidence of the effect of all these factors on office space additions. In particular, their analysis shows that real office rents, vacancy rates, office employment growth expectations, and FIRE employment growth volatility have a statistically significant effect on metrowide office construction. Cost-Related Factors and Availability of Capital Cost Factors Keeping constant office-property prices, higher development costs, including the cost of financial capital (interest rates), construction costs (cost of labor and materials) and land costs, reduce investment profitability and discourage office construction. Sivitanidou and Sivitanides (2000) show that construction costs and interest rates do indeed have a negative and statistically significant effect on metrowide office completions. Kling and McCue (1987) provide also evidence of the effect of interest rates on office building investments. Availability of Capital The availability of investment capital for new office construction projects may be influenced by government policies, the public equity market, the private equity market and the private lending industry. For example, Clapp (1993) notes that some observers have attributed the excessive overbuilding of office space in the 1980s to the abundance of capital, as lenders, facilitated by the reduced regulations put in place in the early 1980s, appeared overly zealous to provide real estate loans. In the private equity market, the focus of institutional investors on office buildings at the expense of other property types may have also contributed to the office construction boom of the 1980s. In the public equity arena, publicly traded real estate management companies (REITS) help channel investment capital (a share of which may be diverted to new development projects) into real estate markets by allowing small investors to participate in real estate investments. After the office market crash of the early 1990s, institutional lenders have adopted stricter lending practices (e.g. increased preleasing requirements among others), which may have reduced the availability of capital for office construction during the 1990s. OVERVIEW OF OFFICE MARKET ANALYSIS Against this background, the purpose of office market analysis is to help pro-active (as opposed to re-active) office investment decisions and development design by looking at and evaluating the forces that determine movements in the broader office market, as well as the more specific location and site factors that may influence project success. As is the case for the other property types, we can distinguish two major components in office market studies: the macroeconomic component and the microeconomic component (see Figure 14.4). Given the high volatility of office markets, the macroeconomic component of office market studies is especially important. Its three major objectives are to: - 390 -
Figure 14.4 Overview of Office Market Analysis OFFICE MARKET ANALYSIS A. Macro Analysis of Office B. Micro Analysis of Office Markets Projects/Marketability Analysis Analyzing Market Strength Positioning Target Markets on their Office Market Cycle Addressing Questions of Timing Assessing Office Locations Designing Marketable Projects Assessing Project Viability from the Market Perspective Analysis components/ Analysis Components: Indicators of market strength: Analyzing Office Locations o Space demand and determinants o Completions and determinants Analysis elements: o Space Rents o Locational Amenities o Supply-demand imbalances o Firm/productive amenities o summary measures (rental o Worker/residential amenities change, demand-supply gaps) o Prestige and Visibility o Locational Constraints Analysis Methodologies Accounting Techniques: Analyzing Office Projects/ Analyzing Assessing Project Demand-Supply Gaps: Simplistic View: Feasibility Net Absorption Demand-Supply Gap, = Office Employment Growth GAP = x Space/Worker Analysis Elements: Net Absorption o Project Rents/Lease Rates, + Replacement Demand Informed View: Development Densities - Available Supply Net Absorption o Project Absorption and = f (Office Employment Growth, Cumulative Revenue Schedules Office Rents, Expectations) Econometric Techniques: Analysis Techniques: Analyzing office market dynamics Accounting and Hedonic Forecasting expected movements in: Valuation Approaches Office Employment Growth and o Net Absorption Net Absorption can be estimated o New Construction through: o Real Rents o Vacancy Rates Aggregate Disaggregate Accounting Accounting Approaches Approaches Financial Feasibility Analysis - 391 -
Analyze and evaluate broader office market strength Identify the target market s position on the rent, vacancy, and construction cycle Address questions of timing Analyzing office market strength at the time of analysis and its position on the real estate cycle will help the analyst better anticipate the market s potential movements over the project s expected holding period. Identifying a market s position on the cycle requires an assessment of the extent of disequilibrium, or the degree of mismatching between the demand for and the supply of office space. This is not an easy task because of the extreme volatility of the office space market. It is, however, a very critical step given that the fortunes of individual actors/projects within a metropolitan office market are driven to a great extent by this idiosyncratic cycle. Within this context, the macroeconomic component of office market analysis can help address prudently the question of whether it is appropriate to enter a given market at a particular point in time. Evaluating office market strength and prospects requires the analysis of office space demand at the margin (net absorption) and its determinants, existing inventory, completions and its determinants, office space rents, and supply-demand imbalances. The interplay of office space demand and supply gives rise to two summary measures of the state of the market-- rental change and supply-demand gap, which, in theory, must be consistent in terms of their implications regarding market strength. As in the case of the other property types, the analyst can use either accounting or econometric techniques for analyzing office markets at the macro level. Accounting methodologies can help the analyst develop rather simplistic estimates of future demand, supply, and the demand-supply gap. There are, however, several issues in using these techniques, especially for longer forecast periods. Econometric techniques can help explore the underlying behavioral relationships and feedback effects among the key variables that drive the market for office space and then use them as basis for more accurately forecasting its future movements. The microeconomic component of office market studies focuses on the competitive strength and most likely performance of the proposed project. Its focus is the evaluation of office locations, the identification of the most marketable office development features for a given site, and the assessment of project viability from the office market perspective. In particular, analysis of office locations focuses on: The site s locational amenities and advantages, including productive amenities, that is, amenities that can increase office-firm productivity, such as proximity to other firms, freeway access, access to CBD, etc., and worker amenities, that is, amenities that are valued by the employees of office firms, such as the quality of the public school system, crime rates, access to shopping and entertainment opportunities, etc. (Sivitanidou 1994 and 1996) Visibility of the site and prestige of the location within the urban fabric Locational constraints in terms of growth regulations, local zoning and other institutional controls that may hamper commercial real estate development - 392 -
Analysis of office project viability from the market perspective focuses on: Estimation of achievable office rents through competitive differential techniques or hedonic methodologies that account for lease characteristics, space characteristics, project amenities, and location attributes Estimation of the project s expected absorption and revenue schedules In the next two chapters, we elaborate first on the macroeconomic aspects of office market studies (Chapter 15) and then focus on the microeconomic analysis of office development projects (Chapter 16). CHAPTER SUMMARY The purpose of office market analysis is to look at and evaluate those factors that determine office project success. These factors include timing, location, and project design and are inherently linked to the nature and dynamics of the forces that drive the demand for and supply of office space. Office space demand is primarily driven by employment growth in the FIRE and the Service sectors. Such growth is not expected to reach the highs of the 1980s in the coming years for a number of reasons. Empirical studies have shown that, for given office employment levels, office space demand responds to movements in rental rates and officeusing-firm expectations for employment growth. This suggests that estimates of office space demand by simple multiplication of expected office employment growth by a space-perworker norm may lead to serious inaccuracies, as they ignore the potential effect of movements in such factors. A trend of declining square feet per office employee has been observed in the 1990s, in contrast to the 1980s when such ratio was rising. Although these patterns seem to be connected with declining real rents in the 1980s and increasing real rents in the 1990s, other more permanent influences may be at work. Trends in this ratio will be crucial in determining office space demand in the future. The supply of office space is driven by factors influencing office-property income and development costs. As such, new office construction is driven by office rent levels, vacancy rates, expectations regarding office market strength, market volatility/risk, construction costs, the cost and availability of capital, and land costs. The experience of the 1980s has shown the supply of office space to be highly price elastic, but the experience of the 1990s points to a more disciplined behavior. Within this context, the purpose of the macroeconomic analysis of office markets is to evaluate their strength, assess their position on the rent-vacancy cycle, and make prudent forecasts with respect to their future movements. The analyst needs to focus on such crucial market indicators as existing office space inventory, vacancy rates, lease rates, net absorption, and new construction. The microeconomic component of office market analysis focuses on the evaluation of project location, identification of the most attractive office development features, and the assessment of project performance in terms of lease rates and absorption schedule. - 393 -
QUESTIONS 1) Discuss which factors and why are important for successful office development. 2) Discuss the factors that contribute to the cyclical nature of the office market. 3) Discuss the trends in the square-feet-per-employee ratio during the 1980s and the 1990s, potential drivers of movements in such ratio, and prospects in the years ahead. 4) Discuss the major determinants of office space demand. 5) Discuss the major determinants of office space supply. 6) Describe the major steps in office market analysis. REFERENCES AND ADDITIONAL READINGS Carn, N., J. Rabianski, R. Racster, and M. Seldin. 1988. Office Market Analysis. Chap. 11 in Real Estate Market Analysis: Techniques and Applications. Englewood Cliffs, NJ: Prentice- Hall. Clapp, J. 1993. Empirical Research on Office Market Dynamics. Chap. 2 in Dynamics of Office Markets. Washington, D.C.: The Urban Institute Press. DiPasquale, D. and W. Wheaton. 1996. The Operation of Nonresidential Property Markets. Chap. 11 in Real Estate Markets and Urban Economics. Englewood Cliffs, NJ: Prentice Hall. Hendershott, P. and E. Kane. 1992. Causes and Consequences of the 1980s Commercial Construction Boom. Journal of Applied Corporate Finance, 5:1, 61-70. Kling, J. and T. McCue. 1987. Office Building Investment and the Macroeconomy: Empirical Evidence 1973-1985. AREUEA Journal, 15:3, 234-255. Sivitanidou, R. 1994. Urban Spatial Variations in Office-Commercial Rents: The Role of Spatial Amenities and Commercial Zoning. Journal of Urban Economics, 38, 23-49. Sivitanidou, R. 1996. Do Office-Commercial Firms Value Access to Service Employment Centers? A Hedonic Value Analysis within Polycentric Los Angeles. Journal of Urban Economics, 38, 23-49. Sivitanidou, R. 2002. Office Rent Processes: The Case of U.S. Metropolitan Markets. Real Estate Economics, 30:2, 317-344. Sivitanidou, R. and P. Sivitanides. 1999. Office Capitalization Rates: Real Estate and Capital Market Influences. Journal of Real Estate Finance and Economics, 18:3, 297-322. - 394 -
Sivitanidou, R. and P. Sivitanides. 2000. Does the Theory of Irreversible Investments Help Explain Movements in Office-Commercial Construction? Real Estate Economics, 28:4, 623-661. Wheaton, W. 1987. The Cyclic Behavior of the National Office Market. AREUEA Journal, 15, 281-299. - 395 -