“Demand has been sluggish this cycle, with net absorption weaker than in previous cycles, which means there's not enough demand to produce meaningful occupancy growth,” said Reagan. The nation's current office-occupancy rate is 84%, which does not compare favorably to previous cycles.

One consequence of tougher occupancy is that leasing costs remain high, Reagan pointed out. “This speaks to a softer recovery, tougher fundamentals and the fact that tenants are changing the way they think about space and are demanding high improvement dollars to fit out their space.”

What Green Street calls RevPAF growth—changes in occupancy and net effective rents blended into one metric—pales in comparison to what the office markets achieved in the late '90s and prior to '07, said Reagan. He predicted that rent growth will be “steady-ish,” with acceleration expected to come later than the other major sectors. He added that the outlook for office is favorable compared to other major property types for the long term.

So where are we in the cycle? For office, most property types are still in growth mode, said Reagan. “Low-barrier-to-entry office is still early in the game—on the cusp of recovery and expansion—and has lagged other major sectors. High-barrier-to-entry office is a little bit further along in the game.” For example, the San Francisco and New York markets are showing signs of deceleration, and he expects this trend to continue in the coming years.

NOI growth, on the other hand, presents something positive for office, which has been slower to recover in this arena. Because of longer average lease term, tends to lag in recovery mode, but also tends to outperform in deceleration because of long-term leases, Reagan said. “Office is poised to hit the sweet spot over the next few years in terms of NOI growth; we expect a good story in the next few years.”

Also positive is that asset values are sitting at all-time highs for office real estate, at about 10% above the prior peak in 2007, Reagan said. Office values are lower than the overall Green Street Commercial Property Index, cap rates have flattened out and there is some evidence that lower-quality office real estate has seen cap-rate pressure and downward value pressure. “We are still in a yield-starved environment globally. We will see a lot of capital looking for a home in US gateway real estate.”

With regard to office transaction volume, (and this information is focused on CBD transactions), overseas buyers are busier than ever, particularly in gateway markets. Also, domestic private buyers have been net sellers. This is in contrast to the last cycle where domestic private buyers were very aggressive. “Looking at 2016, REITs are in a position of being net sellers after being net acquirers over the previous several years, but this is still developing,” said Reagan.

Office total returns have lagged historically in both public and private markets, and office has underperformed the majority of sectors in both public and private, unlike self-storage, which has been a very strong performer in the public market for the last 20 years, Reagan said.

Regarding pricing, office still looks expensive if you consider average returns. And except for the lodging sector, office has highest capex of all. “Landlords need to spend a lot of money to scratch out a pretty meager income growth for some time.” Reagan added that office is trading at a 7% discount to gross asset value, and expected returns on public office real estate are low, so this is not a great story.

Regarding high-barrier-to-entry vs. low-barrier-to-entry markets, high-barrier has been the consistent winner between 2005 and 2016 in both public and private markets, Reagan said. What has led to this? First, capex as a percent of NOI takes a much smaller bite out of high barrier than low barrier, and over the long term NOI and rent growth has been significantly better for high-barrier markets than low-barrier markets; high-barrier consistently outperformed low-barrier markets.

Will high-barrier markets continue to show this kind of outside growth in the years to come? Reagan said while high-barrier markets are expected to continue to outperform low-barrier markets overall, there are a number of markets (San Francisco and Midtown Manhattan, for two) that will see meaningful deceleration due mostly to supply creeping in in New York and the tech market beginning to slow in San Francisco—other regions are coming in to fill the demand from the tech market. Some key high-barrier markets are decelerating.

Over the long term, high-barrier markets will have meaningfully better NOI growth over low-barrier ones, but the advantage may not be quite as strong as what we've seen in the last 20 years, said Reagan. Historically, the spread has been higher than 250 bps, but both types of markets are priced pretty closely together today. Reagan said he thinks high-barrier markets are still a better bet for the long term, but for investors with shorter time horizons (say, five to seven years), it's a toss-up. The most attractive markets are the higher-growth western US markets.

An attendee survey showed that 43.5% of attendees thought high-barrier office markets were the most attractive investment opportunity; 37.2% said low-barrier markets with repositioning potential were most attractive, and 19.3% said it was about even. Reagan said the toughest market for new development as far as high-barrier markets go is West L.A. because of its congested layout.

NEWPORT BEACH, CA—As companies continue to seek greater efficiencies in office space and demand more tenant improvements, the office sector continues to struggle with occupancy rates and subdued demand, Green Street Advisors' senior analyst Jed Reagan told attendees at a company webinar yesterday. The webinar, titled “US Office Real Estate: Fundamentals & Valuation,” gave a breakdown of office fundamentals and how they compare to previous cycles—and the overall answer was, “Not well.”

Reagan started off by explaining that office-demand growth has been subdued compared to job growth—the driver for office-demand growth—in this cycle. He said he expects that office demand will stay subdued for the short term because companies are now focused on efficient use of space, which translates to putting more employees into fewer seats.

Fortunately, supply has been in check in most markets, Reagan said, with supply on an annual basis has been modest this cycle compared to previous ones. The Sunbelt and tech markets are seeing more supply, but absorption has been steady in those markets, so “it's pretty decent story by and large,” he said. Fundamentals are expected to slow in New York due to supply coming in, he pointed out.

Net absorption has picked up in recent years, but is still quite a bit less than the prior cycle, and Reagan said tenants are taking more of a pause due to macro headwinds. Tech markets are leading the pack in terms of absorption, whereas Houston and the DC metro have been sluggish.

“Demand has been sluggish this cycle, with net absorption weaker than in previous cycles, which means there's not enough demand to produce meaningful occupancy growth,” said Reagan. The nation's current office-occupancy rate is 84%, which does not compare favorably to previous cycles.

One consequence of tougher occupancy is that leasing costs remain high, Reagan pointed out. “This speaks to a softer recovery, tougher fundamentals and the fact that tenants are changing the way they think about space and are demanding high improvement dollars to fit out their space.”

What Green Street calls RevPAF growth—changes in occupancy and net effective rents blended into one metric—pales in comparison to what the office markets achieved in the late '90s and prior to '07, said Reagan. He predicted that rent growth will be “steady-ish,” with acceleration expected to come later than the other major sectors. He added that the outlook for office is favorable compared to other major property types for the long term.

So where are we in the cycle? For office, most property types are still in growth mode, said Reagan. “Low-barrier-to-entry office is still early in the game—on the cusp of recovery and expansion—and has lagged other major sectors. High-barrier-to-entry office is a little bit further along in the game.” For example, the San Francisco and New York markets are showing signs of deceleration, and he expects this trend to continue in the coming years.

NOI growth, on the other hand, presents something positive for office, which has been slower to recover in this arena. Because of longer average lease term, tends to lag in recovery mode, but also tends to outperform in deceleration because of long-term leases, Reagan said. “Office is poised to hit the sweet spot over the next few years in terms of NOI growth; we expect a good story in the next few years.”

Also positive is that asset values are sitting at all-time highs for office real estate, at about 10% above the prior peak in 2007, Reagan said. Office values are lower than the overall Green Street Commercial Property Index, cap rates have flattened out and there is some evidence that lower-quality office real estate has seen cap-rate pressure and downward value pressure. “We are still in a yield-starved environment globally. We will see a lot of capital looking for a home in US gateway real estate.”

With regard to office transaction volume, (and this information is focused on CBD transactions), overseas buyers are busier than ever, particularly in gateway markets. Also, domestic private buyers have been net sellers. This is in contrast to the last cycle where domestic private buyers were very aggressive. “Looking at 2016, REITs are in a position of being net sellers after being net acquirers over the previous several years, but this is still developing,” said Reagan.

Office total returns have lagged historically in both public and private markets, and office has underperformed the majority of sectors in both public and private, unlike self-storage, which has been a very strong performer in the public market for the last 20 years, Reagan said.

Regarding pricing, office still looks expensive if you consider average returns. And except for the lodging sector, office has highest capex of all. “Landlords need to spend a lot of money to scratch out a pretty meager income growth for some time.” Reagan added that office is trading at a 7% discount to gross asset value, and expected returns on public office real estate are low, so this is not a great story.

Regarding high-barrier-to-entry vs. low-barrier-to-entry markets, high-barrier has been the consistent winner between 2005 and 2016 in both public and private markets, Reagan said. What has led to this? First, capex as a percent of NOI takes a much smaller bite out of high barrier than low barrier, and over the long term NOI and rent growth has been significantly better for high-barrier markets than low-barrier markets; high-barrier consistently outperformed low-barrier markets.

Will high-barrier markets continue to show this kind of outside growth in the years to come? Reagan said while high-barrier markets are expected to continue to outperform low-barrier markets overall, there are a number of markets (San Francisco and Midtown Manhattan, for two) that will see meaningful deceleration due mostly to supply creeping in in New York and the tech market beginning to slow in San Francisco—other regions are coming in to fill the demand from the tech market. Some key high-barrier markets are decelerating.

Over the long term, high-barrier markets will have meaningfully better NOI growth over low-barrier ones, but the advantage may not be quite as strong as what we've seen in the last 20 years, said Reagan. Historically, the spread has been higher than 250 bps, but both types of markets are priced pretty closely together today. Reagan said he thinks high-barrier markets are still a better bet for the long term, but for investors with shorter time horizons (say, five to seven years), it's a toss-up. The most attractive markets are the higher-growth western US markets.

An attendee survey showed that 43.5% of attendees thought high-barrier office markets were the most attractive investment opportunity; 37.2% said low-barrier markets with repositioning potential were most attractive, and 19.3% said it was about even. Reagan said the toughest market for new development as far as high-barrier markets go is West L.A. because of its congested layout.