Office sector works its way back

It has been one of the slowest real estate sectors to recover from the recession, but the office market is finally being fueled by job growth. Falling vacancies are giving birth to rising rents, which will benefit real estate investment trusts (REITs) in the space.

"2014 ended with lots of good news and optimistic data, for both the macro-economy and the office market," noted Ryan Severino, senior economist at Reis, a commercial real estate analytics firm. "GDP growth, labor market growth, net absorption and vacancy are all trending in the right direction and at a faster pace over time. Barring some idiosyncratic shock, there is no reason to believe that these trends will not persist in 2015."

Office buildings in New York
Timur Emek | Getty Images
Office buildings in New York

The national office vacancy rate declined by 10 basis points in the fourth quarter of 2014 to 16.7 percent. It is now down 90 basis points from the cyclical high reached at the end of 2010, according to Reis. Net absorption of 10.974 million square feet was the highest figure since the third quarter of 2007, which Reis deems the best evidence yet that the recovery in the office market is finally gaining some momentum. Absorption is now exceeding construction at a fast clip.

"We are definitely seeing things steadily improving. Office was slower to recover than a lot of sectors of commercial real estate," said Jed Reagan of Green Street Advisors, an independent research firm. "We are seeing just in the past year that conditions are improving, and fundamentals are accelerating."

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New demand pushed effective rent higher by 1.1 percent for the quarter and by 3 percent for the full year. This is more than double the rent growth of the previous quarter. Rents have now been rising for 17 consecutive quarters. The acceleration in growth bodes well for office REITs, which had lagged the larger real estate recovery.

"We like companies skewed to high barrier markets, like New York, Boston, San Francisco and West Los Angeles," noted Reagan. "Washington, D.C., has been the weakest link."

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Boston Properties is a strong leader in the group. The REIT owns 172 properties, comprised primarily of Class A office space, according to its latest quarterly earnings report. Still, Executive Chairman Mort Zuckerman calls the current economy "puzzling," which accounts for continued anxiety in the sector.

"In the markets that we are in, we're still finding a good deal of activity, particularly in the projects that we have," said Zuckerman in an October 2014 conference call with analysts. "I think we all have to be aware of an overall economic environment that is not the most positive. There is a great deal of uncertainty in the business community because of the anxiety over the national leadership, but the real thing is that American business has slowed down."

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While investors have complained about government job cuts hitting the Washington, D.C., office market hard, it and New York remain the two tightest markets in the country, as measured by vacancy rate, according to Reis. San Francisco is not far behind.

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Still, D.C.-focused REITs such as Corporate Office Properties, Washington REIT and Brandywine Realty Trust are seen as less attractive bets by some analysts, while Douglas Emmett and Highwoods Properties are seen by some as good values. Low-barrier, suburban markets are still lagging the overall recovery, as prime markets gain steam.

"Vacancy compression should slowly begin to accelerate and the potential exists for the market to outperform our expectations if the economy is even stronger than currently forecast. This is the most sanguine that we have been about the economy and the office market since before the recession," added Reis' Severino.