The Las Vegas office market continued to languish in the first quarter of 2009. New completions increased this quarter over last and net absorption fell dramatically. The transaction volume increased slightly over last quarter, but mostly represented office tenants looking to downsize or find lower rents, rather than the expansions or new business creation that was needed to fuel recovery. Landlords began to decrease asking rents and prices. The teaser rates that circulated in the fourth quarter of 2008 became the advertised asking rates of this quarter. Developers put new projects on hold, which should reduce the amount of vacant space that would otherwise have entered the market in 2009 and 2010.
Employment in sectors traditionally associated with office space decreased for the third straight quarter. Between February 2008 and February 2009, a total of 7,900 office jobs were lost, with the largest losses experienced by the professional and business services sector. The bright spot for office employment has been the health care and social assistance sector, which has posted quarterly gains in employment in every quarter since the second quarter of 2004. Since increases in occupied office space tend to lag about 6 to 12 months behind employment increases in these sectors, employment numbers are the best indicator of eventual recovery for the office market. Unemployment in the Las Vegas MSA stood at 10.1 percent as of February 2009, up from 5.1 percent in February 2008.
A total of 631,690 square feet (SF) of new office space was completed in the first quarter of 2009. All product types had new completions this quarter and new office product was located in the Northwest and Southwest submarkets. Most of this space began construction before the existence of the recession became readily apparent in mid-2008. Vacancy in this newly completed space stood at approximately 76 percent. Prominent new completions included Montecito Point (187,000 SF), The Arroyo Business Center (139,000 SF), 3755 Breakthrough Way at the Nevada Cancer Institute Campus (101,000 SF), Summerlin Medical Center (78,000 SF) and Centennial Hills Center (58,000 SF).
Forward supply of office space in the Valley stood at 904,000 SF in the first quarter of 2009. This was a significant drop from last quarter, when 1.8-million SF was either under construction or planned to begin construction by the end of 2009. Some construction on projects has been halted and many other proposed projects are presently unable to find financing. Over half of this forward supply was in Class A professional office. The Southwest had more forward supply space than any other submarket and its share of forward supply has increased since last quarter. Despite the fact that the Southwest submarket was very hot through the recent development bubble, the continued determination of developers to build in a submarket with one of the Valley’s highest vacancy rates indicates their faith that population growth there will continue to be explosive when the local economy recovers.
Office vacancy increased for the tenth straight quarter, reaching 20.9 percent. The previous low was in the third quarter of 2006, when office vacancy stood at 8.7 percent. If one included sub-lease space, the Las Vegas Valley had a total of 9,137,967 square feet of office space in search of a tenant. Assuming a pre-housing bubble net absorption of 350,000 square feet per quarter, that represented a 6.5 year supply of office space. This over-supply of office space put downward pressure on asking rental rates. Many short-term “teaser rates” were now being promoted as full term asking rates, and even stalwarts of optimism like American Nevada Corp began to lower its published rates. These revaluations
increased the volume of signed leases this quarter over last, with the odd side-effect of the average asking lease rate in decreasing by $0.01 as price-conscious tenants snapped up deals. When adjusted for inflation, the average asking rent for office space in the Valley actually decreased by $0.01 this quarter, and has decreased by $0.26 since it peaked in the fourth quarter of 2007.
The Valley’s highest vacancy rate this quarter was in the Airport submarket, at 27.9 percent. East Las Vegas, Henderson, North Las Vegas, Northwest and Southwest all had total vacancy near or above 20 percent. The Downtown and West Central submarkets, which experienced very little new office construction since 2003, had the Valley’s lowest vacancy rates at 9.2 percent and 13.5 percent respectively.
There has been a sharp increase in the available inventory of office properties for sale on either an owner/user or investment basis over the past year, with a corresponding decline in the inventory that has actually sold. The average asking price for owner/ user sales dropped this quarter over last, but remains higher than in the first quarter of 2008. The average asking price for investment sales has dropped from $330 psf in the first quarter of 2008 to $246 psf this quarter. The average price of buildings that sold in the first quarter on an owner/user basis was $155 psf. There were no investment sales of office product this quarter.
Class A office properties had a higher vacancy rate than other property types, at 28.3 percent. They also had the Valley’s highest availability rate of sub-lease space at 3.3 percent. Much of the pain Class A office is feeling can be traced to the Airport and Southwest submarkets, both of which had vacancy rates exceeding 65 percent. In the case of the Airport submarket, one project, the Town Square development, represented 63 percent of the submarket’s Class A vacancy. The problem in the Southwest comes down to ill-timed development, as the Southwest’s Class A market expanded from 0 to 170,972 square feet in just three years, the same time period in which net absorption of such space dropped by over 500,000 square feet Valley-wide. In response to lower demand, asking rental rates for Class A professional office dropped Valley-wide by $0.05 per square foot (PSF) on a full service basis (FSG) this quarter over last.
Net absorption of the different classes of professional office space followed slightly different trajectories since the mini-recession of 2001/2002. Class A office saw conservative growth for most of this decade and then spiked in 2007, only to fall hard in 2008. First quarter 2009 performance suggests that demand for Class A office will continue to fall through 2009. Net absorption of Class B office peaked in 2004 and has decreased in each quarter thereafter. Demand for Class B space fell off a cliff in 2008 and seems likely to continue to fall at a similar rate through 2009.
Class C office space tends to cater to small businesses and incorporates more owner-user space than either Class A or B product. Net absorption of Class C product followed the residential bubble quite closely, expanding quickly in 2004 and 2005 and then contracting in 2007 and even more quickly in 2008. First quarter performance suggests that Class C office product faces a brighter year ahead than either Class A or Class B product. This change in trajectory might be a function of pricing. The average asking rental rate for Class C space increased from $1.71 psf FSG in the fourth quarter of 2002 to a peak of $2.50 psf FSG in the fourth quarter of 2007. Since then, it has decreased by $0.39 to $2.11 psf FSG.
Office occupancy tends to track closely with employment in sectors traditionally associated with office. While these sectors have contracted by 14,000 jobs since they peaked in the first quarter of 2007, the office occupancy rate has declined by 10 points, from 89.1 percent to 79.1 percent. During that same two year period, occupied office square footage actually grew through the four quarters of 2007 before declining for the four quarters of 2008. From the first quarter of 2007 to the first quarter of 2009, total occupied office space has increased by over 700,000 square feet. Currently, the Valley is supporting 149 square feet of occupied office space per office job, compared to 137 square feet per office job in the first quarter of 2007, and 117 square feet per office job in the first quarter of 2003. These numbers suggest that there might be a long way to go before demand for office space increases.
We think that local firms will continue to downsize through 2009, and probably for six to twelve months after the Las Vegas Valley has experienced sustained increases in office employment. Asking rents should continue to decline, as landlords compete for scarce tenants. Most lease activity in 2009 will consist of tenants moving within the Valley, searching for lower rent or smaller spaces. If government estimates of national economic recovery in the fourth quarter of 2009 are correct, we predict that the Valley office market will begin to see recovery in late 2010 or early 2011.
Metrics for Recovery
Despite the somewhat bleak picture painted above, the national and local economies will recover. We think that several metrics can be established to predict how quickly that recovery will occur for the commercial real estate market. The health of the commercial real estate market is tied directly to employment. Employees take up space, and thus increases in employment eventually translate into demand for more space. Our study of the Southern Nevada real estate market for the past ten years has taught us that there is usually a 9 to 12 month lag between employment gains and increases in occupied square footage. Employment will, therefore, be the best indicator of impending recovery for the real estate market. Of primary importance to the Southern Nevada economy is employment in the leisure & hospitality and construction sectors. Gaming revenue is probably the best indicator of employment growth in the leisure & hospitality sector. Renewed employment growth in construction requires an increase in demand for new homes. A good indicator of renewed demand for new homes, and thus an increase in construction jobs, is a shrinking gap between the median price for a new home and the median price for an existing home. As employment in leisure & hospitality and construction grows, employment in other sectors will follow suit and we will begin to see an increase in demand for commercial space.
The Congressional Budget Office and Federal Reserve chairman Ben Bernanke recently predicted that economic recovery should begin by the end of 2009, while some economists have offered more dire predictions for the future. Whoever turns out to be correct, there can be no doubt that we are seeing the imposition of business fundamentals in our economy. Businesses that want to stay in business will need to show a profit. Lenders who want to stay in business will have to lend money only to people who can pay it back. For genuine recovery, American citizens, businesses and governments will need to pay down their debts, which will require both time and discipline. In the meantime, growth, when it comes, could be slower than we have become accustomed. We think that if there is an end to the recession in the last quarter of 2009, we will see gains in employment in 2010 and increases in the occupancy of commercial real estate in 2011.
– John Matt Stater