Fall 2006

Construction Watch: Supply Increase Not Expected to Halt Recovery
ver the past three years, as the economic rebound took hold, office employment surged while construction activity slowed precipitously from levels experienced between 1999 and 2001. This imbalance between supply and demand led to an acceleration in the office market’s recovery over the past year. Vacancy reached its cyclical peak at the end of 2003 at 17 percent and has since fallen to 14 percent, with most of the improvement registered in the past year. These tighter conditions have supported almost universal rent growth. Marketwide, the average effective rent is up 6.2 percent from the market’s cyclical bottom, reaching $21.24 per square foot by mid-2006. The slowdown in construction in recent years is due to a variety of factors, including skyrocketing materials costs and a more cautious lending environment. While overall commodity prices continue to rise, steel prices have stabilized after reaching their peak last year, and developers and contractors have also adjusted ordering procedures to better hedge against rising costs.


Office Completions and Net Absorption


Overall, there are currently more than 2,000 projects totaling 350 million square feet in the pipeline. To assess the risk that new supply may pose over the next 28 months, it is important to first Office Completions and Net Absorption determine just how much of the space will actually be delivered. We analyzed the pipeline based on several factors, such as the size 150 of projects and/or the current stage of planning or construction, to better estimate the probability of properties being delivered over 75 the survey period. Based on our analysis (please see footnote1 for methodology), projected deliveries for 2007 and 2008 total 91 and 102 million 0 square feet, respectively. It is important to note that medical office Completions space accounts for close to 13 million square feet, or 14 percent, of -75 projected deliveries in 2007. An additional 14 million square feet Net Absorption of new medical office space is also projected for 2008. This -150 illustrates the growing market for medical office space as health 1996 2000 2002 2006* 2008* care continues1998at the forefront of new2004 creation. Additionally, be job *Projected medical office space carries an occupancy rate of close to 93 percent and net absorption has increased annually for the past five years. A significant portion of expected deliveries in 2007 and 2008 are build-to-suit projects that are heavily or fully pre-leased. While this will soften the impact of 91 million square feet of completions in 2007, many companies moving into new build-to-suit facilities will be leaving large availabilities of competitive space in other properties.
Projected Office Completions as a Percentage of Inventory

0 Completions -75
Net Absorption

-150 1996 1998 2000 2002 2004 2006* 2008*




In spite of higher development costs, the number of projects in the construction pipeline has increased dramatically as market conditions tightened. Developers are on track to deliver 75 million square feet of office space in 2006, which will represent the first annual increase in new supply in six years but will still fall below anticipated absorption levels for the year. Furthermore, new supply will add only 1.3 percent to existing stock, compared to an average of 1.5 percent over the past 10 years.
Projected Office Completions as a Percentage of Inventory



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Methodology – Projected deliveries include projects under construction with given completion dates and a ratio of projects currently listed as planned. We assumed that 20% of planned buildings less than 750,000 square feet would be completed in 2007, while just 5% of buildings 750,000 – 1,000,000 square feet would be completed in 2007, and 8% no buildings larger than 1,000,000 square feet. This was done to balance any issues in the raw data that may arise from the lag time in reporting, as many projects listed as planned may now be under construction, while other planned properties will never be built. For our 2008 projections, we assumed that 40% of currently planned properties less than 750,000 square feet would be delivered. 2007also took 20% of the properties between 750,000 – 1,000,000 square feet and 15% of properties above 1,000,000 square We 2006 6% feet. While 30 months is typically not enough time to build a 1,000,000 square foot skyscraper, very few of the properties above 1,000,000 square feet in our survey are skyscrapers, but rather are a portfolio of 3-5 suburban mid-rise properties that are being built simultaneously and can be delivered.


Net Absorption


West *Projected The West region includes a mix of high barrier-to-entry coastal markets, recovering tech markets and top growth markets that still have a significant amount of land available for development. High barrier-to-entry markets including Los Angeles and San Francisco are expected to deliver new inventory totaling less than 1 percent of stock in 2007. Recovering high-tech markets such as Portland, San Jose and Oakland are expected to deliver similar amounts of space in 2007, but for different reasons. While developable land is abundant in these markets, they are still in the initial phases of the Projected Office Completions recovery cycle and must first absorb large tracts of vacant space as Percentage of before embarking on newadevelopments. Inventory of additions to In terms existing inventory, top growth markets such as Phoenix, Las Vegas 8% and Inland Empire will deliver the largest amount of space as a percentage of existing inventory in 2007. Completions in Phoenix 2006 are 6% expected to reach 7.5 percent of2007 existing supply in 2007, well above the historic highs in the 4-5 percent range. Phoenix is expected to maintain above-average job growth, however, and new 4% construction will cause only a temporary shift in the supplydemand balance. The Inland Empire’s office market is smaller in 2% terms of overall square footage, lending more weight to completions when expressed as a percentage of existing inventory. In addition, the market is well-positioned to benefit from overflow 0% s e h ix go demandmfromenpriciertacoastal areas such asegas Angeles,tykeepingtiany Los n, D.C. oun Diego onal lla ac pir l an i ca V Da Be ho E At C n Ch Na Sa nd increases inP vacancy to minimalPalm Las shingto range levels. a Inl st
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help further its recovery. With a vacancy rate of over 20 percent, it is difficult to see how more construction will help the Dallas market, but the addition of 2 percent of supply in 2007 should not have a noticeable adverse impact on the market. Midwest The Midwest has the lowest amount of new construction projected for 2007. This is in sync with the above-average vacancy rates in many of the region’s markets. Cincinnati is the lone market with above average construction activity in 2007. Although the Midwest continues to struggle with below-average demand, limited new deliveries through 2008 will provide the area with an opportunity to slowly absorb a substantial portion of vacant space and provide owners with the opportunity to begin to reduce concessions and raise rents. Detroit will lag, but markets such as Chicago and Minneapolis should perform better over the next 12 months. Northeast Most markets in the northeast are projected to deliver more than 2 percent of stock in 2007, including Northern New Jersey at 2.3 percent and Philadelphia and Washington, D.C., at 2 percent. Close to half of Philadelphia’s planned completions in 2007 are attributed to the Comcast Center, which is heavily pre-leased and therefore should not negatively impact the market. Construction in New York mainly consists of the NY Times Tower and the Bank of America building, which are also heavily pre-leased, and the high rents they are achieving should actually benefit the market by lifting the effective rent owners are able to achieve within the immediate submarket. Planned completions for 2007 in Boston are almost all medical office or life sciences buildings that have registered strong pre-leasing or are build-to-suit. Developers’ reluctance to initiate new speculative projects should be encouraging to investors in Boston, where the market is still in the early stages of recovery. Summary Points • Nationally, if current projections hold, 91 million square feet of new office space will be delivered in 2007, outpacing projected positive net absorption of 75 million and raising the vacancy rate by 10 basis points. • The surge in development activity is concentrated in only a few markets, as most markets will continue to see average to below-average deliveries in 2007. • Developers in high-growth markets (Phoenix, Inland Empire, Las Vegas, West Palm Beach) are projected to deliver large amounts of new space in 2007, but consistent above-average job growth in these markets will limit increases in vacancy. • Markets in the Midwest have the lowest projected increases in supply for 2007 and 2008, which will provide them the opportunity to absorb in earnest some of the large tracts of vacancy that remain. • The projected increase in construction will create temporary shifts in the supply-demand balance, leading to slightly higher vacancy rates, but not enough to materially impact pricing.

Southeast In the Southeast, Atlanta and West Palm Beach are the only markets where additions to stock in 2007 are forecast to reach more than 2.5 percent. The risk is greatest for Atlanta as the current vacancy rate remains around 17 percent and the introduction of significant new space, without strong pre-leasing, will hinder any positive momentum being built this year. Fort Lauderdale, Miami, Tampa, Jacksonville and Orlando are all projected to add between 1.4 percent and 2.2 percent to existing inventory. Strong demand, leading to increased absorption levels in all these markets, will allow them to absorb new completions without impacting their vacancy rates.
Completions and Net Absorption as a Percentage of Stock
2007 Projected Completions 2.5%

2007 Projected Net Absorption

1.5% 1.0% 0.5% 0.0% Midwest Northeast Southeast West Southwest

Southwest (Texas) While Houston is projected to deliver less than 1 percent of stock in 2007, the other Texas markets will deliver slightly over 2 percent. Austin, a recovering tech market, has seen its vacancy rate drop 500 basis points from its cyclical high and low levels of completions will

The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied may be made as to the accuracy or reliability of the information contained herein.

Alan L. Pontius, National Director / 415.391.9220 / • Yitzie Sommer, Research Manager / 212.430.5178 /
©2006 Marcus & Millichap

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