Office Market Report

Transition to a Landlord’s Market

March, 2006

By Mike Hamasu, Director of Consulting and Research, Colliers Monroe Friedlander

Honolulu’s office market posted its third consecutive year of strong occupancy growth, with nearly 250,000 square feet recorded for 2005. Since the beginning of 2003, more than 650,000 square feet of new occupancy filled Honolulu office buildings.

This healthy growth is the result of more than 9,000 office positions being added to payrolls in Honolulu since the end of 2001. The Professional and Business Services category generated the lion’s share of this increase by posting growth of more than 8,650 jobs, or an annual employment growth rate of 4.2 percent over this four-year period.

Vacancy rates fell from a decade high of 13.75 percent at mid-year 2002 to 8.74 percent at year-end 2005. Having fallen below the market equilibrium point of 10 percent at mid-year 2005, the Oahu office market continued its expansion phase and reached an island-wide office vacancy rate of 9 percent by year-end.

As a lagging economic indicator, real estate vacancy rates tend to decline only after a period of economic growth. This growth provides a stimulus for businesses to begin hiring, resulting in increased demand for office space. Hawaii’s economy is benefiting from the upswing in air passenger arrivals, increased construction activity, rising personal incomes and property values – all significant factors that boost businesses’ optimism and confidence.

Transition Underway

During the past two years, Honolulu’s office market has gradually transitioned from a tenant’s market to that of a landlord-controlled market.

  • Landlords reduced concessions on lease renewals of existing tenants. New prospective tenants also experienced a reduction in free rent and improvements.
    • Large office users, sensing the limitations of relocation options, started early negotiations of lease extensions and fixed rental rates.
    • Migration from pricey Class A and B properties to Class C functional space occurred. In the early 1990s, many businesses had the opportunity to occupy prime view offices at bargain rates, due to a glut of Class A high-rise space. Recent increases of rental rates in Class A and B buildings prompted these tenants to migrate back to Class C buildings. CMF Consulting tracked more than 140,000 square feet of occupancy growth in Class C properties over the past two years.
    • As suburban markets filled, tenants sought alternative locations with more abundant office space. East Oahu, Windward Oahu and the Kapiolani Corridor posted vacancy rates below 7.5 percent.

The rise in fuel costs, wages, construction materials and labor result in an upward push of building operating expenses. In 2006, CMF Consulting estimates a 9.84 percent increase in expenses.What to Anticipate in 2006
Increasing Rental Rates and Operating Expenses

  • • The low interest rate environment, volatility of the stock market and healthy state economy make Hawaii’s commercial real estate attractive to U.S. mainland investors. Many recently purchased office properties and will boost asking rents in an effort to meet target yields.
    • With rental rates experiencing a 5 percent to 7 percent annual increase over the past two years, it is anticipated that, as vacancy rates continue to decline, these rates will likely increase 8 percent to12 percent over the next year.

Office net absorption for 2006 should remain positive, with vacancy rates falling below 8 percent by year-end 2006. The pace of absorption should slow by as much as 50 percent from the previous three-year average of 220,000 square feet per year. (2002 through 2005 posted the strongest three-year performance of the office sector in more than 15 years.)Office Net Absorption Slowdown

  • • With current unemployment rates at 2.8 percent, the shortfall of skilled labor will hamper future hiring and slow office space demand.
    • Rising wages will spur inflation concerns. Businesses will call for increased worker productivity to justify paying higher salaries. The need to increase wages will further impact hiring efforts.

Office Development Still Not Feasible, but …

  • The loss of office development sites in the Central Business District and Kapiolani submarkets to high-rise residential condominium developers will limit future supply of office buildings.
    • Rising construction materials and labor costs reduce the current feasibility of new construction. Rents would have to increase at a significantly higher pace than the cost of construction.
    • Should rents reach a level that makes office development possible, under-performing Class C and Class D properties offer the opportunity to rehabilitate and redevelop.

Rents to Grow by Double-Digits

Noted economists from Bank of Hawaii, the University of Hawaii and the state of Hawaii forecast job growth to continue for 2006 at a range of 1.5 percent to 1.6 percent above year-end 2005 figures. This is a noted decline from the more robust forecasts for 2005, when these economists predicted job growth of 2.1 percent to 2.4 percent. In the office sector, job growth between October 2004 and October 2005 was 3.1 percent, significantly stronger than the economists’ Oahu job forecasts. Should hiring continue at this current pace, or even slow slightly, the office market should post healthy net absorption for 2006.

The CMF Consulting Supply Demand Model, which tracks office tenants in the market looking for space and the available supply of office space, noted a decrease in office demand levels for November and December 2005. After robust leasing activity in the third and fourth quarters of 2005, we anticipate a strong first quarter of 2006, followed by a marginal reduction in leasing activity by the third quarter of 2006. Despite this anticipated slowdown of office growth, positive absorption should drive vacancy rates down below 8 percent by year-end 2006.

Landlords appear to be testing the market rent equilibrium levels by pushing asking rents higher. In the past year, asking rents at Class A full-service buildings rose by 7 percent. Class B properties experienced rental increases of 5.6 percent and Class C rents rose 5.8 percent. These increases result in renewing, relocating and new tenants paying $0.12 to $0.17 more per square foot per month. This translates into occupancy costs for a 10,000-square-foot tenant of $29,000 to $40,000 more annually. Of the full-service rental rate increases, operating expenses contributed from 30 percent to 40 percent.Currently, the East Oahu, Windward Oahu and Kapiolani Corridor markets post vacancy rates below 7.5 percent and, by year-end 2006, the Leeward market should also post vacancy rates below this level. As the office market continues to tighten, the shortage of available office space will lead to increased competition among tenants. This will further increase rental rates, and CMF Consulting anticipates double-digit jumps in rents by year-end 2006.

Since the beginning of 2005, negotiated triple net Class A office rents have risen by as much as $0.20 per square foot per month. Anecdotal evidence collected by CMF Consulting also indicates that landlord concessions are shrinking.

Nationally, the commercial real estate investment market posted healthy returns over the past few years, outshining the poor returns and increased volatility of the stock market. But as interest rates rise and capitalization rates are compressed, alternative investments will garner increased investor attention. For Honolulu’s office properties, many investors anticipate appreciation based on rising property values and replacement cost. The improvement of Honolulu’s office rents should further boost the attractiveness of office investment in Honolulu.
CMF Consulting conducted a study that reviewed Class A and Class B office operating expense data. More than 3.75 million square feet of office properties over a three-year time period were analyzed. The objective was to provide a benchmark for property managers and leasing agents. The study enabled property managers to be proactive in identifying and establishing programs that addressed property deficiencies.

Building Operating Expenses to Increase by 10 Percent

Subsequent to this study, CMF Consulting held discussions with various utility companies, tax assessment office officials and security, insurance and janitorial companies to determine projected increases to fees and charges. Among the office buildings surveyed, electricity consumption, building systems and maintenance, real property tax and janitorial services constituted the largest expense components. Combined, these categories constituted more than 80 percent of the total operating expense.

  • Volatile Energy Prices Drive Electricity Rates Higher: Electricity — principally for lighting and air conditioning — constitutes the largest component of a building’s operating expense, comprising nearly 27 percent of the total. The forecast is that rapid increases in fuel and oil will cause electricity charges to rise more quickly than in the past two years. CMF Consulting estimates that in 2006, electricity prices will increase nearly 9 percent over last year’s rates.
  • Strong Real Estate Market Increases Property Tax Rates: Real property tax (“RPT”) constitutes more than 16 percent of a building’s operating expense. The dramatic rise in property valuations over the past few years resulted in a 27 percent increase in RPT expense since 2002/2003. CMF Consulting projects that real property tax rates will increase by 15 percent over the next year.
  • Insurance Rates to Jump: The devastating impact of Hurricanes Katrina, Rita and Wilma on properties throughout the U.S. Gulf Coast resulted in property losses in the billions. Insurance companies and ultimately reinsurance companies will be left to fund much of the losses. As a result, property insurance rates are anticipated to increase by 20 percent to 25 percent over the next year.
  • Low Unemployment Impacts Low Wage Positions: CMF Consulting found through discussions with various building service vendors that the state’s low unemployment rate is impacting the ability to secure and hire additional staff. Security guards, janitorial and landscape maintenance staffs are lured away by competitors or higher-paying industries. The building service vendors interviewed anticipate an increase in the competition for entry-level or unskilled labor, which will ultimately drive wage increases 5 percent to 10 percent.

Concluding Remarks

CMF Consulting projects positive net absorption will continue to drive vacancy rates downward in 2006. This will further exacerbate the difficulty that tenants face when seeking relocation or expansion opportunities. Typically, when available office space decreases below a market equilibrium point (pegged at a 10 percent vacancy rate), office rents increase at a significantly faster pace than inflation. Should rents increase to the point when it becomes financially feasible to develop office space, new supply gets added to the market.After more than a decade of stagnant conditions, in which office tenants could negotiate for months of free rent and a healthy tenant-improvement allowance, the change will come as a shock for tenants used to dictating terms for their lease renewals. Landlords who have been hard-pressed to fill their building vacancies will now have the opportunity to wait for market demand fueled by healthy job growth to drive rents higher.

Several factors will likely restrict new development over the near term. Expensive land prices, increasing construction costs and a lack of development locations inhibit the development of new office buildings. In fact, many of the potential office development sites have been used for high-rise residential condominium developments.

Currently, the average net office rent of roughly $1.47 per square foot per month would have to more than double to make it worthwhile for a developer to build in urban Honolulu. The lower cost basis for land in West Oahu would contribute to a developer being able to “pencil” an office development sooner than in other areas on the island.

 

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