On the Rise

Higher office rents forecast for 2007

March, 2007

By Mike Hamasu, Consulting and Research Director, Colliers Monroe Friedlander Consulting, a division of Colliers Monroe Friedlander Inc.

In light of the strong demand for office space and the resulting decline in availability, the Oahu average asking rate, which aggregates the increases among rents for all buildings, posted its strongest annual increase in 2006. Full-service asking rents rose to an average $2.59 per square foot per month (psf/mo). Landlords are capitalizing on the increased competition for space and have raised their asking rents accordingly. Bargain rents for office space are becoming a rarity in this heated marketplace, since even Class C property rents have risen by more than 23 percent over the past four years, to $2.41 psf/mo.

For the fourth consecutive year, Honolulu’s office market posted positive net absorption, which drove vacancy rates to their lowest levels since 1991. The current office market up-cycle has posted nearly 900,000 square feet of growth since it started in 2003. In fact, Honolulu’s office sector has added nearly 10,000 jobs since October 2003, resulting in the strongest period of consistent growth experienced during the past 20 years. By year-end 2006, more than 249,757 square feet of new tenancy resulted in Honolulu’s islandwide vacancy rate falling to 7.0 percent.

Strong leasing activity reported among the central business district’s Class A properties served as the principal driver of this growth. More than 145,000 square feet of new occupancy, two-thirds of Honolulu’s positive absorption, can be attributed to these properties. Class B properties posted a fifth consecutive year of healthy growth, with more than 76,000 square feet of added tenancy in 2006. Occupancy among Class C properties had increased by 27,898 square feet at year-end 2006.

Year-end 2005 witnessed a transition from a tenant-powered to a landlord-controlled market, as vacancy rates fell below the market equilibrium level of 10 percent for the first time in more than a dozen years. During 2006, the office market continued to strengthen, posting strong absorption and a record annual increase in rents. However, the residential real estate cycle appears to have peaked, and commercial markets typically follow suit. While business activity remains strong, many companies complain about the difficulty in hiring skilled, technical and entry-level employees. Economists have warned that capacity constraints and inflation will slow the robust economy Hawaii has enjoyed over the past few years.

Significant job growth fueled much of the increased demand for office space. Further examination of these figures shows that the professional and business services component increased at the rapid pace of roughly 6 percent over the past year (October 2005 to October 2006). This increase followed a 5 percent growth rate recorded for 2005. At the current 2.4 percent unemployment rate, it is doubtful that the fast pace of job growth in the office sector can continue. Colliers Monroe Friedlander anticipates a likely slowdown in the pace of absorption for 2007 as businesses reduce their expansion plans due to a moderating economy and a lack of job candidates.

A decline in home sales is another factor that may influence the direction of the office market for 2007. Office occupancy increased as real estate support services, such as residential title and escrow, mortgage and sales offices, sprung up rapidly to meet the increased demand in home sales. After peaking in 2005, the residential market slowed in sales activity in 2006. Should this trend continue, it is likely that many of the newly opened sales support offices will consolidate or close, creating a negative impact on the office sector. A review of Colliers Monroe Friedlander lease statistics for 2004 to 2006 shows that 19 percent of the total square footage leased during that period was to construction or real estate-related businesses. This is nearly double the amount calculated for the 2002 to 2004 time frame, making the office market more vulnerable to a downturn in the residential marketplace.

Relocation Decision Made More Difficult

During 2006, landlords tested the market pricing elasticity by posting asking rents for buildings that were 10 percent to 20 percent over their previously posted rates. In a few cases, landlords were met with increased vacancy as tenants migrated to cheaper spaces. However, the majority of existing tenants elected to renew their leases at the higher rental rates.

Compounding difficulties faced by tenants has been the escalation in construction costs. Despite being approached with a lower base rent and attractive tenant improvement allowances, prospective tenants considering relocation have had to consider the rising costs associated with building out their new offices. These costs, which averaged roughly $45 to $55 per square foot in 2003, could now easily top $75 per square foot.

Further exacerbating this situation, landlords that would have given roughly $40 to $55 per square foot in tenant improvement allowances in 2003 to prospective tenants, are now only offering $20 to $25. As a result, tenants are footing larger construction bills to outfit their offices. Relocating an existing office has thus become more costly and more difficult to justify financially.

Colliers Forecasts Increased Occupancy and Rents

A look at the number of tenants vs. the vacancy rate (pg. 44) indicates tenant demand still remained fairly healthy with a slight up-tick in the vacancy rate, between the third and fourth quarters of 2006. There appears to be an increase in the number of tenants currently looking for space whose lease expirations are coming up in the second and third quarters of 2007.

Taking into account these indicators, Colliers Monroe Friedlander forecasts that vacancy rates for 2007 will continue on a downward track, resulting in a 6 percent to 6.5 percent vacancy rate at year-end. Net absorption is anticipated to fall between 100,000 to 150,000 square feet by year-end 2007.

Concluding Remarks

Honolulu’s office sector has enjoyed four consecutive years of solid growth and is anticipating a continuation of the same for 2007. Despite warning clouds of a slowing economy, a drop in residential home sales, and inflationary pressures, the 2007 office market will likely encounter a decline in vacancy rates, increased competition for prized office space, and a healthy increase in rents. Landlords will capitalize on this supply-constrained market, in which the building of new offices is unlikely in the urban core, and boost rents accordingly.

Although these increases were anticipated, tenants will likely face stiffer increases over the near term as competition for prime office space becomes more intense. Many leases are being negotiated with 4 percent annual escalation clauses, which steadily increase the initial rent by as much as 20 percent over a five-year term.Class A office full-service gross asking rents increased from $2.62 psf/mo to $2.85 psf/mo over the course of 2006. Class B office rents rose by 9.61 percent. Class C office rents posted the largest increase in rents, jumping by 11.53 percent, from $2.16 psf/mo to $2.40 psf/mo, a full $0.25 psf/mo increase. The islandwide average rent rose to $2.59 psf/mo from $2.36 psf/mo, a 9.85 percent increase.

Despite a quickening in the pace of office rental rate growth, several years of sizeable gains will be required to offset the jump in land prices and increases in construction costs. It is highly unlikely that there will be new office development in downtown Honolulu for a number of years. The story is different for the West Oahu market. Developers have already announced plans for new office projects in the Kapolei market, where land prices are substantially less than in Honolulu’s urban core.

It’s easy to understand the tenant’s point of view when rents begin to escalate. However, to keep things in perspective, it should be remembered that, over the past 20 years, office rents posted extreme volatility, with a number of years in which rents declined. In fact, if an investor had placed funds in the CPI index in 1986, he would have gotten a cumulative return of 65 percent, or roughly a 3.27 percent annual return, compared to an office rent index cumulative return of 23.52 percent, or a 1.18 percent annual rate of return. In other words, office rents had remained extremely stable for nearly a decade before the recent upward movement occurred.

A sharp upward trend in rents began in the third quarter of 2005. Tenants should anticipate an increase of 10 percent to 12 percent in rents for 2007. In addition to a jump in rents, building operating expenses will increase. The combination of the volatility in electricity prices and the anticipated increase in the state’s minimum wage should push electricity, janitorial, security and landscaping costs upward as well.

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Mike Hamasu