Office-Using Employment Gains, Reliance on Concessions to Nudge Down Phoenix Vacancy in Second Half

ECONOMY
Phoenix, AX – July 29, 2011 – (RealEstateRama) — Although office net absorption in Phoenix remains negative year to date, the local economic recovery gained traction in the second quarter. Businesses added 14,900 positions locally, a 0.9% staffing boost, in the past six months, compared to a nationwide increase of 757,000 jobs, or 0.6%. Improvements have been greatest in the Valley’s healthcare and leisure and hospitality sectors, with white-collar industries dampening overall growth through the first quarter of 2011. Nevertheless, Phoenix white-collar employers rebounded in the most recent quarter. Local office-using employment sectors augmented payrolls by an estimated 2,800 workers, a 0.7% quarterly gain, mirroring the healthy white-collar improvements that have been recorded nationally. Recent hiring announcements from companies including Safelite, Humana, Yelp and Easy Energy Systems Inc. support projections for a sturdy, albeit late, white-collar recovery through year end, helping to stabilize space demand. U.S. emp loyment will increase by a projected 1.65 million jobs in 2011, including to 39,000 positions in Phoenix, a 2.3% marketwide gain. Local white-collar sectors are anticipated to hire 5,600 workers, growth of 1.3%.

FUNDAMENTALS
Existing local businesses proved resilient in the face of depressed leasing velocity over the past three months. The amount of office space leased quarter over quarter declined by 22%, yet metro vacancy fell 20 basis points to 27%. The divergent trends indicate that the pace of shuttering and downsizing tenants slowed this summer, likely foreshadowing steadier space demand in the second half. Asking rents held steady over the past three months, but the abrupt absence of rent declines does not indicate demand-driven rent appreciation in the near term. Instead, the effects of space turnover and declining levels of deeply discounted sublet space are buoying average rents. Tenant incentives remain in use due to stubbornly high vacancy, even in stronger submarkets like the Camelback Corridor. There, effective rents average 10% to 12% below asking rents, not including tenant improvement allowances. Space improvement budgets typically start at $40 per square foot for credit-worthy t enants leasing shell space, while allocations peak near $30 per square foot for second-generation buildings. Owners will remain competitive through the remainder of the year, and asking rents cuts of 1.4% to $21.48 per square foot will drive a 30-basis point vacancy improvement to 26.6% in 2011.

SALES
Acquisitions of distressed and stabilized office assets are contributing to erratic quarter-over-quarter sales trends in Phoenix, though longer-range comparisons demonstrate receding office prices. Similar to primary metropolitan areas where prices are beginning to tick higher, investor competition in Phoenix remains elevated by institutional, REIT and out-of-state buyers; however, the markedly higher rate of local operational distress compels many of these buyers to maintain wider risk premiums. So far this year, the median price has slid 20% to $82 per square foot, while average cap rates have ascended 70 basis points to 9.5%. While operations will steady in the second half of the year, several consecutive quarters of improvement will be needed to drive a reversal in office property values.

EMPLOYMENT & ABSORPTION
Job creation in the Valley’s white-collar businesses has lagged both overall metro employment growth and nationwide office-using employment gains. Nevertheless, the 2,800 local white-collar positions added in the second quarter of this year, a 0.7% increase, should serve as the impetus for ongoing payroll expansion throughout the year. Phoenix office space absorption has been equally choppy since the end of the recession. The recent improvements in professional and business services hiring, however, underpinned net absorption of 125,200 square feet, following negative net absorption of 244,200 square feet during the first quarter. In the second half of 2011, white-collar payrolls are forecast to expand by another 8,500 workers, or 2%. Consequently, office leasing will remain steady, lifting net absorption to 225,500 square feet for the year.

VACANCY
Uneven white-collar hiring trends have caused metrowide office vacancy to fluctuate between 26.9% and 27.2% since the beginning of 2010. Average vacancy in the second quarter was 27%, down 20 basis points quarter over quarter but in line with the year-earlier rate. Occupancy improvements were greatest Downtown, where leasing by law firms, especially, supported a 180 basis point improvement in the second quarter to a metro-low rate of 21.2%. With many tenants taking the opportunity to trade up to more desirable space throughout Phoenix, Class A leasing has remained steady. Average vacancy among the metro’s top-tier office product was 28.4% in the most recent quarter, a 30 basis point quarterly reduction and 170 basis points below the average rate in the second quarter of 2010. Class A space demand will persist throughout the year, helping push down vacancy 30 basis points to 26.6%.

ASKING RENTS
Asking rent trends remain erratic. Although metro and submarket vacancies linger at elevated levels that are not conducive to rent growth, rental rates have risen in a number of areas due to variations in space availability. Additionally, as sublet space with drastically below-market asking rents is leased and removed from available inventory, overall rents will ascend. As such, in the Downtown and the Camelback and San Tan corridors submarkets, where inventory is turning over more quickly, asking rents rose on quarter-over-quarter basis. Marketwide asking rents were unchanged at $21.53 per square foot in the second quarter but stood 4.2% below rates in the second quarter of 2010. Elevated concessions persist though, and owners of Class B/C properties, in particular, must aggressively pursue tenants. Rents will vary going forward, but the projected fourth quarter rate of $21.48 per square foot will mark a 1.4% annual decrease.

SALES & INVESTMENT
Institutional buyers continue to ramp up activity in Phoenix. Though quarter-over-quarter deal flow dipped in the second quarter, velocity was up 42% in the past year, while the number of sales involving properties priced at $10 million-plus increased 156%. Large buyers have been active metrowide, acquiring both stabilized and troubled properties. As a result, pricing has fluctuated and the second quarter median price climbed 15% to $88 per square foot. The median price during the first half of 2011, however, was $82 per square foot, 20% below the final two quarters of last year. Cap rates will vary in step with prices. Cap rates average 9.5% year to date, but initial yields for Class A assets or buildings occupied by top-quality tenants start in the 7% range. Out-of-state buyers, particularly from California, are targeting smaller, more aggressive deals with double-digit returns.

About Lee & Associates Arizona Research Division
The Lee & Associates Arizona Research Division regularly publishes economic and commercial real estate reports. Publication are available at our web site at: www.LeeArizona.com