Think back to the office market in 1985. People were saying, “Nothing can go wrong. People are still coming.” Those same people were soon singing the blues because surprise, surprise, something went wrong. Is Atlanta’s office market as hot as it seems?
BizNow’s recent article The Fastest-Growing Office Rents in the U.S. Are in Atlanta touts Atlanta’s office market success, but, in my opinion, fails to give a full picture. I see it more as a tale of two cities—the institutional office market and the local office market.
Midtown + Buckhead: Hot Atlanta Office Markets
Media likes to focus on the hot markets, like Midtown and Buckhead, and rightfully so, according to these stats: “Rents at premier office spaces in Midtown and Buckhead have risen 14.2% since last year, breaking the $50/SF ceiling for the first time.” Plus, 2.2M SF of new prime office space is underway with “Selig Enterprises breaking ground on 1105 West Peachtree St. and Cousins beginning work on Norfolk Southern’s new headquarters at 650 West Peachtree St.”
But these markets are driven by national and international companies, major law firms, WeWork and high-tech companies.
But What About Local Markets?
The small business, entrepreneurial and professional office market is different. Unlike big companies, this market segment cannot pay the $50+ rents.
Say a local company’s 10-year lease at $20/SF expires, and the new rate is $35/SF. That tenant will most likely relocate to a different submarket or downsize. As mentioned before, advances in technology, efficient office concepts and flexible working arrangements make this possible. This should lead to less new development than in previous expansions.
New Construction = High Rents
New developments typically do not occur until existing building occupancies tighten and rents justify new construction. Yet in this cycle, the rent in new buildings is SIGNIFICANTLY higher than those in existing buildings due to soaring costs for land, materials and labor. For example, the new office buildings in Avalon rent for $40/SF while Alpharetta’s existing Class A office buildings still lease in the low- to mid-$20/SF range.
This cost-driven spike in rents has the potential to be problematic. If the rise in new speculative developments continues and absorption decreases, the $40+ rents could drop 25% or more. For well-capitalized owners, this might not result in the financial distress of previous cycles, but it will surely put a huge dent in ROI.
What Does This Mean for the RE Cycle?
Office absorption has been strong in 2019, and Colliers International is bullish on office absorption for the rest of this year. While I think demand will continue to result in decent absorption, I do wonder, “At what level will rents stabilize?”
Forecasters keep pushing out the recession date, but eventually something will rattle the market. (In my opinion, WeWork is the snake in the woodpile.) People like to argue this time will be different—but they always say that.
With investors and developers banking on BIG increases in rents to achieve their desired return, I would be more conservative in my underwriting.