U.S. Speculative Office Development Has Increased 44% In 2 Years
Following the Great Recession, many developers this cycle have been hesitant to move forward on office projects without a tenant signed to avoid the mistakes of the last downturn. But some have changed their tune of late and say, to capture a new era of business and avoid higher construction costs, shovels need to hit the ground posthaste.
The 130M SF of total U.S. office product under construction at the end of 2018 is down from a cyclical high of 136M SF at the end of 2016, according to CoStar Market Analyst David Pierce. Speculative office development, or development without a tenant attached, is up 37% over the past two years, accounting for just over 46M SF of office currently under construction.
Developers around the country say it all comes down to capturing tenants in a late cycle and avoiding high construction costs that don’t appear to be abating anytime soon. A continuing trade war with China, which is already driving the cost of U.S. infrastructure projects higher, also threatens to escalate prices for already costly office projects.
“I think if you were to poll the real estate community in Boston and top-tier markets, those who go spec first generally win,” Boston-based Skanska USA Executive Vice President and Regional Manager Charley Leatherbee said. “In order to harvest and get these tenants, you have to have product available.”
Skanska is no stranger to speculative office development, both in Boston and elsewhere in the U.S. The developer went spec on the 400K SF office component at 121 Seaport in Boston’s Seaport District. The building is now fully leased to Alexion Pharmaceuticals and technology company PTC and sold in December for $455M. The developer is also going spec on Two Drydock, a $128M, 225K SF office in the Seaport.
Skanska has also built spec office projects in Seattle and Houston, and Leatherbee attributes the success to tenants needing space quicker than ever in leading markets. The days of companies inking leases as far as five years in advance are over. Skanska in particular is looking to capture business from rapidly growing companies with immediate space needs. In Boston, Leatherbee sees no problem in going spec on projects around 500K SF, but cautions against going much larger.
Leatherbee also recognizes there may be only so much runway left this development cycle.
“If I had a shovel-ready project, I would go vertical,” he said. “But in six months or a year? I don’t know.”
While Skanska is bullish on near-term spec development, Boston’s overall 1.6M speculative office development under construction represents 39% of total office supply currently underway. The U.S. national average for office speculative development is 36% of total office currently under construction, according to CoStar. Bigger spec office waves are found in places like Orange County, California, Phoenix or Nashville, Tennessee.
Of the 1.3M SF of office product under construction in Orange County, 91% is speculative development. In Phoenix, 66% of the 3.5M SF office under construction has yet to sign a tenant, and Nashville’s 65% unsigned space of the total 4.8M SF of office under construction is also well above the U.S. average.
Los Angeles-based Fenix Development Project Manager Mike Loretz says his firm is pursuing most of its speculative projects in Phoenix, and he doesn’t view it as overbuilding. Loretz said the rise in spec development is simply a response to market conditions that give developers confidence to move forward with office projects even if there isn’t a tenant signed.
U.S. job growth is particularly high in Arizona, and developers are lining up to capitalize on the booming regional economy with future office projects. Economists expect Arizona to add nearly 550,000 jobs by 2026, and 75% of those are expected to be in Greater Phoenix.
Fenix is going spec on a 265K SF office project and 44K SF of retail in the first phase of its planned 1.9M SF Watermark mixed-use development in Tempe, Arizona. Given the numerous universities in Greater Phoenix, the Tempe submarket’s sub-2% Class-A office vacancy rate and expected future job growth in the next decade, Loretz feels confident in pursuing speculative development further.
“We’re getting calls from employers saying we need hundreds of square feet in a matter of months,” he said. “We decided to go spec solely because of the job growth and that below 2% Class-A figure.”
Rising construction costs that could increase even further with geopolitical tension like a trade war with China are also a concern to some developers. Take Atlanta for example: Construction costs in Atlanta have risen just over 5% annually since 2004, the highest cost acceleration in the city's history, according to a new CBRE report. Developers in Atlanta have said the escalation may actually be closer to a 1% increase each month. Loretz has experienced similar price increases in Arizona.
“We pulled the trigger on a lot of bids earlier on in 2018, but the bids we waited on increased almost 10%,” he said.
Not everyone is sold on construction weighing heavily on the minds of developers going spec.
While rising costs have played a part in driving developers to push forward with projects, Transwestern Managing Partner John Thomas cautions that the fluctuation in construction costs should never be a reason to start a building. While it might be something to consider, he says focusing on market fundamentals and returns on investment should be leading influencers in development decisions.
Even with threats of a prolonged trade war with China and rising building costs, Thomas said trade wars are usually more talk than action.
“[Office developments] are 20- to 30-year assets,” he said. “This is a global economy, and it’s something we need to be cautious about, but not too worried about.”