MARKETUPDATE

Fall 2006

Construction Watch: Supply Increase Not Expected to Halt Recovery

ver the past three years, as the economic rebound took Overall, there are currently more than 2,000 projects totaling

O hold, office employment surged while construction

activity slowed precipitously from levels experienced
between 1999 and 2001. This imbalance between supply and
350 million square feet in the pipeline. To assess the risk that new
supply may pose over the next 28 months, it is important to first
Office Completions and Net Absorption
determine just how much of the space will actually be delivered.
demand led to an acceleration in the office market’s recovery over We
150
analyzed the pipeline based on several factors, such as the size
the past year. Vacancy reached its cyclical peak at the end of 2003 of projects and/or the current stage of planning or construction, to
at 17 percent and has since fallen to 14 percent, with most of the better estimate the probability of properties being delivered over
improvement registered in the past year. These tighter conditions the75 survey period.
have supported almost universal rent growth. Marketwide, the Based on our analysis (please see footnote1 for methodology),
average effective rent is up 6.2 percent from the market’s cyclical projected
0 deliveries for 2007 and 2008 total 91 and 102 million
bottom, reaching $21.24 per square foot by mid-2006. square feet, respectively. It is important to note that medical office
The slowdown in construction in recent years is due to a variety space accounts for close to 13 million square feet, or 14 percent, of
Completions
-75
of factors, including skyrocketing materials costs and a more projected deliveries in 2007. An additional 14 million square feet
Net Absorption
cautious lending environment. While overall commodity prices of new medical office space is also projected for 2008. This
continue to rise, steel prices have stabilized after reaching their peak illustrates the growing market for medical office space as health
-150
last year, and developers and contractors have also adjusted care continues
1996 be at the2000
1998 forefront of new2004
2002 job creation.
2006* Additionally,
2008*
ordering procedures to better hedge against rising costs. medical office space carries an occupancy rate of close to*Projected
93 percent
and net absorption has increased annually for the past five years. A
Office Completions and Net Absorption significant portion of expected deliveries in 2007 and 2008 are
build-to-suit projects that are heavily or fully pre-leased. While this
150 will soften the impact of 91 million square feet of completions in
2007, many companies moving into new build-to-suit facilities will
75 be leaving large availabilities of competitive space in other
properties.
0
Projected Office Completions
Completions as a Percentage of Inventory
-75
Net Absorption 8%

-150
1996 1998 2000 2002 2004 2006* 2008* 6% 2006   2007
*Projected

In spite of higher development costs, the number of projects in 4%

the construction pipeline has increased dramatically as market
conditions tightened. Developers are on track to deliver 75 million
2%
square feet of office space in 2006, which will represent the first
annual increase in new supply in six years but will still fall below
anticipated absorption levels for the year. Furthermore, new supply 0%
. o
ire ix ta lla
s go h as .C ty
ie g
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will add only 1.3 percent to existing stock, compared to an average Em
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of 1.5 percent over the past 10 years. Inla
st
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sh
i n
Or
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We Wa
Projected Office Completions
as a Percentage of Inventory
1
Methodology – Projected deliveries include projects under construction with given completion dates and a ratio of projects currently listed as planned. We assumed that 20%
of planned
8% buildings less than 750,000 square feet would be completed in 2007, while just 5% of buildings 750,000 – 1,000,000 square feet would be completed in 2007, and
no buildings larger than 1,000,000 square feet. This was done to balance any issues in the raw data that may arise from the lag time in reporting, as many projects listed as
planned may now be under construction, while other planned properties will never be built. For our 2008 projections, we assumed that 40% of currently planned properties less
than 750,000 square feet would be delivered.  2007
2006
We also took 20% of the properties between 750,000 – 1,000,000 square feet and 15% of properties above 1,000,000 square
6%
feet. While 30 months is typically not enough time to build a 1,000,000 square foot skyscraper, very few of the properties above 1,000,000 square feet in our survey are
skyscrapers, but rather are a portfolio of 3-5 suburban mid-rise properties that are being built simultaneously and can be delivered.

4%

2%
 -75
Net Absorption

-150
1996 1998 2000 2002 2004 2006* 2008*
West *Projected help further its recovery. With a vacancy rate of over 20 percent, it
The West region includes a mix of high barrier-to-entry coastal is difficult to see how more construction will help the Dallas
markets, recovering tech markets and top growth markets that still market, but the addition of 2 percent of supply in 2007 should not
have a significant amount of land available for development. High have a noticeable adverse impact on the market.
barrier-to-entry markets including Los Angeles and San Francisco
Midwest
are expected to deliver new inventory totaling less than 1 percent of
stock in 2007. Recovering high-tech markets such as Portland, San The Midwest has the lowest amount of new construction projected
Jose and Oakland are expected to deliver similar amounts of space for 2007. This is in sync with the above-average vacancy rates in
in 2007, but for different reasons. While developable land is many of the region’s markets. Cincinnati is the lone market with
abundant in these markets, they are still in the initial phases of the above average construction activity in 2007. Although the Midwest
recovery cycle and must Projected Office large
first absorb Completions tracts of vacant space continues to struggle with below-average demand, limited new
before embarking on new as a Percentage of Inventory
developments. In terms of additions to deliveries through 2008 will provide the area with an opportunity
existing to slowly absorb a substantial portion of vacant space and provide
8% inventory, top growth markets such as Phoenix, Las Vegas
and Inland Empire will deliver the largest amount of space as a owners with the opportunity to begin to reduce concessions and
percentage of existing inventory in 2007. Completions in Phoenix raise rents. Detroit will lag, but markets such as Chicago and
are 6%
expected to reach 7.5 2006
percent of   2007
existing supply in 2007, well Minneapolis should perform better over the next 12 months.
above the historic highs in the 4-5 percent range. Phoenix is Northeast
expected to maintain above-average job growth, however, and new
4% Most markets in the northeast are projected to deliver more than 2
construction will cause only a temporary shift in the supply-
percent of stock in 2007, including Northern New Jersey at 2.3
demand balance. The Inland Empire’s office market is smaller in
2% of overall square footage, lending more weight to
percent and Philadelphia and Washington, D.C., at 2 percent.
terms
Close to half of Philadelphia’s planned completions in 2007 are
completions when expressed as a percentage of existing inventory.
attributed to the Comcast Center, which is heavily pre-leased and
In addition, the market is well-positioned to benefit from overflow
0%
C.
therefore should not negatively impact the market. Construction in
demandmfrom pir
e
enpricier
ix
l an
tacoastal
lla areas
s
i ca
go such ac asegLos
h as Angeles,
D. nt keeping
y
Di
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o
any
na
l

dE Ph
o At Da
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as
V
to
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eC
ou
an Na
tio New York mainly consists of the NY Times Tower and the Bank of
increases
Inl
a n in vacancy to minimal P levels.
a lm L i n g
n g S
st
We
sh
Wa O ra America building, which are also heavily pre-leased, and the high
Southeast rents they are achieving should actually benefit the market by lifting
In the Southeast, Atlanta and West Palm Beach are the only markets the effective rent owners are able to achieve within the immediate
where additions to stock in 2007 are forecast to reach more than 2.5 submarket. Planned completions for 2007 in Boston are almost all
percent. The risk is greatest for Atlanta as the current vacancy rate medical office or life sciences buildings that have registered strong
remains around 17 percent and the introduction of significant new pre-leasing or are build-to-suit. Developers’ reluctance to initiate
space, without strong pre-leasing, will hinder any positive new speculative projects should be encouraging to investors in
momentum being built this year. Fort Lauderdale, Miami, Tampa, Boston, where the market is still in the early stages of recovery.
Jacksonville and Orlando are all projected to add between 1.4 percent Summary Points
and 2.2 percent to existing inventory. Strong demand, leading to
• Nationally, if current projections hold, 91 million square
increased absorption levels in all these markets, will allow them to
feet of new office space will be delivered in 2007, outpacing
absorb new completions without impacting their vacancy rates.
projected positive net absorption of 75 million and raising
the vacancy rate by 10 basis points.
Completions and Net Absorption as a Percentage of Stock
• The surge in development activity is concentrated in only a
2007 Projected Completions
2.5% few markets, as most markets will continue to see average to
2007 Projected Net Absorption
below-average deliveries in 2007.
2.0%
• Developers in high-growth markets (Phoenix, Inland
1.5% Empire, Las Vegas, West Palm Beach) are projected to
deliver large amounts of new space in 2007, but consistent
1.0% above-average job growth in these markets will limit
increases in vacancy.
0.5%
• Markets in the Midwest have the lowest projected increases
0.0% in supply for 2007 and 2008, which will provide them the
Midwest Northeast Southeast West Southwest
opportunity to absorb in earnest some of the large tracts of
vacancy that remain.
Southwest (Texas)
While Houston is projected to deliver less than 1 percent of stock • The projected increase in construction will create temporary
in 2007, the other Texas markets will deliver slightly over 2 percent. shifts in the supply-demand balance, leading to slightly
Austin, a recovering tech market, has seen its vacancy rate drop 500 higher vacancy rates, but not enough to materially impact
basis points from its cyclical high and low levels of completions will pricing.

The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied
may be made as to the accuracy or reliability of the information contained herein.

Alan L. Pontius, National Director / 415.391.9220 / apontius@marcusmillichap.com • Yitzie Sommer, Research Manager / 212.430.5178 / ysommer@marcusmillichap.com

©2006 Marcus & Millichap