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December 13, 2012
Most of us in Puget Sound real estate know the market looks good.
Housing sales and prices are increasing. Seattle and Eastside office markets have seen lower vacancies and higher rents in the last two years. Institutional investors are paying record prices for downtown high rise and suburban office properties. Seattle’s West 8th recently sold for more than $557 per square foot.
Pretty impressive when you compare to the U.S. economy, which continues to expand at anemic levels.
Seattle’s optimism is unavoidable with these headlines: “Amazon purchases 3 blocks; plans to build 3.3 million SF of office space in the South Lake Union market” (in addition to the nearly 2.8 million square feet it already occupies); and “Amazon plans to purchase their 1.8 million SF campus from Vulcan for almost $1 billion.”
At the same time, Vulcan announced it is going to build a 380,000-square-foot expansion for Amazon, separate from that property sale.
This growth means more well-paying jobs for our highly educated workforce. Amazon’s expansion plans translate into approximately 17,000 new jobs in the South Lake Union neighborhood if you consider the standard estimate that it takes 200 square feet to accommodate one employee.
This rapid growth and the increasing talent pool serves as a catalyst, attracting technology companies from outside the region that are finding it difficult to hire qualified employees in their own markets. Companies such as Google, Salesforce, Zynga, Facebook and Splunk are examples of recent expansions to this area for this reason.
I have been told by one technology HR director who is interviewing employees both in Seattle and the Bay Area that employee cost in our region, for similarly qualified candidates, can be as much as 20 percent less. Office space in the Bay Area can also be 50 percent to 80 percent more expensive, adding to Seattle’s attractiveness.
Tenant perks diminish
We should all be thankful to the contribution to the Puget Sound economy of companies like Amazon, Microsoft, Google and Nordstrom. Even Boeing has expanded into Seattle’s downtown high-rise office market for the first time.
These companies are the drivers in this market and have hands down contributed to historic absorption levels of office space in Seattle and Bellevue. The growth of these companies has had a very positive impact, not only on the numbers, but perhaps even more so on the glowing perception of how well our region’s economy is faring.
This is clear to real estate brokers representing tenants who are unable to negotiate deals as attractive as they were only six months ago. Office rents have risen quickly on both sides of Lake Washington, in some cases as much as 20 percent in the past nine months.
Landlords are more bullish about the market prospects and will be even more so for the next couple of years. With a very limited supply of new office space scheduled to be delivered in the next two years and existing capital constraints requiring large pre-leasing requirements, we could see vacancy rates drop into the lower single digits by 2014-15 if the local economy continues to grow.
However, potential pitfalls loom ahead of us following an election that has created regulatory uncertainty in multiple issues affecting commercial real estate. Many businesses have expressed caution as the looming “fiscal cliff” threatens to push the economy into recession if lawmakers are unable to reach a compromise before early next year.
Corporate leverage, a sign of business confidence, is the lowest it has been in decades. On a national level, the real estate industry will likely have to wait until regulatory and political issues are resolved and business confidence is restored before more robust and sustained economic growth can resume.
The effects of this uncertainty have already started to infiltrate the Puget Sound economy that performed relatively well during the first half of the year but was mixed during the third quarter. Between June and July the unemployment rate increased from 7.5 percent to 8.1 percent, then dipped again in August to 7.6 percent.
The public sector shed jobs while the private sector grew, albeit at a slower rate, which mirrors a national trend that has stalled a wider spread recovery. Economic growth has been constrained by state and local governments reigning in deficits and cutting jobs, while the private sector grows moderately.
The Seattle market
Leasing activity in Seattle has slowed from the first half of the year. The office market only accounted for a dreary 58,000 square feet of absorption during the third quarter, compared to the 1.03 million square feet it absorbed during the first half of the year. The vacancy rate for office space in Seattle now sits at 12.01 percent, down from 14.15 percent at the same time last year.
If you take away the absorption attributed to Amazon, the market activity would have been nearly flat, since most companies are simply renewing leases or even downsizing. It is notable that a vacancy rate of 12.01 percent is still considered a tenant’s market.
Market equilibrium doesn’t normally occur until we reach vacancy levels of 8-10 percent, marking a transition towards a landlord’s market. Nevertheless, with all of the optimism prevailing in Seattle there appears to be a shift beginning towards a landlord’s market, in which property owners are gaining the upper hand in lease negotiations.
Tenants that are considering renewals, expansions or moving are seeing fewer concessions from landlords than they would have six to 12 months ago. Concessions include free rent, tenant improvements and subsidized parking.
This trend is most apparent in the limited supply of the most prestigious available space in the post-1990 high-rise properties. Vacancy rates are below 6 percent in this market subsection.
This shift has not yet occurred for what we call “commodity space,” which is most of the available space in the market. It may soon follow if we continue to experience high absorption rates in the quarters ahead.
The Eastside market
On the Eastside, Bellevue’s central business district continued to dominate the leasing market. Absorption of new space for the overall Eastside market totaled 160,000 square feet for the third quarter. The vacancy rate for Eastside office market is now 9.32 percent compared to 9.93 percent at the start of the previous quarter.
The Bellevue CBD is still driven by technology tenants. Caradigm, a Microsoft/General Electric joint venture, moved into 69,000 square feet at City Center and Global Scholar moved into another 31,000 square feet. Other notable transactions and moves include New York Life Insurance from Bellevue Gateway I to 31,000 square feet in the Puget Sound Energy Building and Conover Insurance moving from Kirkland to 16,500 square feet at the Columbia West Building.
Expect tenant demand for Bellevue CBD space to remain strong.
As in Seattle, a tighter market for space in Bellevue’s CBD has led to higher rents, especially for premium and larger contiguous blocks of space. Smaller blocks of commodity space remain plentiful.
Class A CBD rental rates rose 3.6 percent quarter-over-quarter and 7.6 percent during the first three quarters of 2012. Developers are working to entitle their new projects and market them for pre-lease as moderate job growth and climbing rents favor new development. Kemper Development Co. announced an $850 million expansion of Lincoln Square containing 550,000 square feet of Class A office space that will break ground next spring.
The North end, South King County and Pierce County markets posted high vacancy rates at 16.34 percent, 16.72 percent and 17.81 percent, respectively. There are no speculative office projects under construction that would significantly add to inventory. Therefore, expect vacancy rates in suburban markets to decline faster as tenants search for cheaper space.
The Puget Sound region continues to attract interest from institutional investors, especially in central business districts and tech-driven submarkets.
In the 2013 ULI Emerging Trends report, one investor said, “Seattle belongs in the primary category,” which can be attributed to its status as one of the brain power centers. The Bellevue CBD exemplifies this trend with several high rises sold during the third quarter that house local technology companies.
Solid economic fundamentals in the Puget Sound market are expected to continue fueling the hot investment sales market. Let’s hope the investors are right this time and our economy continues to grow along with the rest of the nation. The powers that be and investors were off target in 2006 and 2007.
Leigh Callaghan is senior vice president at Colliers International.