Why Have Office Rents Stalled?

Office leasing activity surged in the second quarter, with activity reaching record levels. In fact, 2Q18 was the second best quarter in the last five years, according to a report from Cushman & Wakefield, and vacancy rates fell to 12.4%. Despite the occupancy gains, rents failed follow. Quarter-over-quarter, rents remained flat at $3.02 per square foot, and class-A and class-B asking rents grew only a penny during the quarter.

“San Diego’s overall asking rate for office space across all classes remained unchanged from last quarter at $3.02 per square foot per month on a full service basis,” Jolanta Campion, director of research in San Diego at Cushman & Wakefield, tells GlobeSt.com. “Notably, the first quarter of 2018 had represented the first time the overall average rate had exceeded the $3.00 per square foot mark since we began tracking data for this market in 2003. The overall average is up $0.09 or 3% year-over-year from $2.93. Class-A and class-B asking rents each added a penny quarter-over-quarter to $3.43 per square foot and $2.81 per square foot, respectively.” For poorer quality spaces, rents actually declined quarter-over-quarter. Class-C rents fell by $0.05.

While rent growth stalled quarter-over-quarter, they are up year over year, 3% or $0.09. In the first quarter of the year, office rents had hit a miniature peak, and they have continued to grow—if nominally—in the class-A space. “While throttling up recently, class-A space has still reached new all-time highs in each of the last three consecutive quarters,” says Campion. “Class-A asking rents are up $0.15 or 5% from a year ago, while class-B actually slid down by a mere $0.02 or 1%. Class-C is up $0.05 or 3% overall from midyear 2017.”

Limited new speculative construction could account for some of the pause in asking rent growth. “One key reason asking rents may not have pushed even further north is because just one mid-sized speculative construction project delivered during the second quarter which did not really tip the rent scale,” Brett Ward, managing director at Cushman & Wakefield, tells GlobeSt.com. Asking rates, especially in the class-A segment, have been much more influenced by new spec development availability, in turn impacting the overall rate. Therefore, as more vacant spec construction projects deliver and subsequently introduce new available space to the market, asking rents are also expected to rise even further ahead.”

Another factor could be a market shift in investment activity. Landlords looking to sell had been pushing rents to make assets more attractive to potential buyers. “The market previously saw more aggressive rent growth stemming from investments, as landlords were pushing rents to align more closely with the underwriting of their assets—underwriting which allowed Buyers to push pricing,” explains Ward. “This was the leading cause of rent growth going back a few years as opposed to actual supply and demand fundamentals. However, with supply and demand fundamentals catching up we anticipate even further rent growth over the coming quarters. We find there to still be plenty of room for growth in the A market guided by new construction. Meanwhile, the widening gap between the A and B markets will subsequently allow more room for the B market to increase.”