Office Market Rebounds

Based on initial quarterly findings, office fundamentals continued to improve during the second quarter. Although demand was not as robust as previous quarters, the fact that supply additions hit a 10-year low helped to support the eight-basis-point decline in vacancy.

As was the case during the first quarter, preliminary second quarter absorption came in short of expectations, as continued macroeconomic uncertainty caused enough uneasiness among business owners for them to delay leasing decisions.

"The office market posted its fifth consecutive quarter of positive net absorption while speculative space under construction reached more than 9.8 million square feet," noted Chris Macke, senior real estate strategist for CoStar Group, in analyzing preliminary numbers. "Second quarter net absorption increased to more than 12 million square feet, a more than 39% increase from the previous quarter's net absorption of 8.7 million square feet."

"However, this level remains down from the robust fourth quarter net absorption rate of more than 24.8 million square feet," Macke said.

CoStar economists will broadcast full second quarter property reports later this month on www.costar.com.

CoStar utilizes a census methodology basing its national results on changes to the entire population of office buildings as opposed to the commonly used practice of sampling, which generates estimates of national results based on results for a portion of the larger markets. CoStar's national population of office buildings upon which its results are based includes more than 10 billion square feet of office properties and believes its research methodology presents the most complete picture of property market conditions across the country.

"We remain confident that strong absorption (at par with 2005 levels) awaits in the not-too-distant future," said Adrian Ponsen, a real estate economist with CoStar. "The most recent job numbers show financial activities employment bottoming out, and professional and business services (60% of office-using employment) growing faster than it did on average during 2005-'07. Combined with today's relatively cheap rents, this foreshadows rapid acceleration in office demand growth."

"Macroeconomic concerns (particularly surrounding the U.S. debt limit) may very well continue to weigh on business owner psychology and leasing during the third quarter. But most conditions necessary for an absorption recovery have already fallen into place," Ponsen said.

Retail: 8 Quarters of Positive Absorption

The recovery continues to push forward, but retailers have throttled back their rate of expansion. Net absorption has slowed to its lowest level since the first quarter of 2010, but weak supply growth has kept vacancies moving in the right direction, according to CoStar economist Ryan McCullough.

"The retail real estate market has now experienced eight quarters of positive net absorption, longer than the office or industrial markets, which have each experienced five consecutive quarters of positive net absorption," Macke said.

"Second quarter net absorption increased to 11.1 million square feet, 700,000 square feet, more than the previous quarter's net absorption of 10.4 million square feet," Macke said. "This however remains well below the robust fourth quarter net absorption rate of more than 26.5 million square feet."

The two-year average net absorption rate is 12.4 million square feet, he noted

"This slowdown should be no more than a temporary slump; an economic uptick in the second half of the year should be enough to stimulate retail sales and encourage retailers to become more aggressive with expansion plans. The construction pipeline is at its lowest level in many years and poses no immediate threat to fundamentals. Expect to see vacancy compression accelerate over the next several quarters," McCullough noted.

Industrial Market Held Back Slightly

The warehouse market continued to gradually improve in the second quarter. As modest demand growth met deliveries that are probably at a low for the cycle, vacancies continued to come in for the fifth consecutive quarter, said CoStar economist Shaw Lupton.

While most industrial indicators have improved markedly in the past year, housing starts remain oppressively low, and the economic events that took a bite out of growth in the first half of the year could continue to hold demand back in the near term, Lupton noted.

"Ultimately, economic expansion will result in a quickening of warehouse absorption. Deliveries are expected to inch up in the near term but should remain low relative to history until warehouse rents grow significantly next year, providing developers with the green light to build," Lupton said.