WESTERN SNAPSHOT, NOVEMBER 2010

Phoenix Office Market

In the absence of true market trends, today’s Phoenix office sector is progressing by benchmarks, which, as they are reached, are slowly but surely moving the market toward stabilization.

During third quarter, Phoenix reached the first of these benchmarks: the completion of 3900 E. Camelback and CityScape. Together, these properties mark the official end of the Phoenix construction cycle. Built by Ryan Cos., 3900 Camelback Center is a 177,520-square-foot, Class A office building within the desirable Camelback Corridor. At 2.5 million square feet upon completion, CityScape will be the largest private investment in downtown Phoenix. Most recently, master developer Red Development completed the project’s $400 million phase one, which includes significant retail space and a 27-story, Class A office tower. Both 3900 and CityScape were delivered at approximately 50 percent leased.

With these completions, the office landscape is now fixed for the foreseeable future and inventory is stabilizing, which allows for a more predictable marketplace. Already, this has spurred two more encouraging new markers — positive net absorption and a slight psychological swing among tenants and landlords.

Year to date, the absorption of Phoenix office space is slightly positive at approximately 180,000 square feet. Though this might sound miniscule, it’s a significant improvement from 2008, when the Phoenix office market recorded 1 million square feet of negative overall absorption, and 2009, when it recorded 500,000 square feet in the red.

An almost unperceivable shift is also occurring among tenants and landlords. Seeing that their boulevard of concessions may be running out, tenants are avidly pursuing long-term leases at lower rates. On the flip side, more landlords are backing away from longer-term leases. At the root of this is a belief that, after 3.5 years of downturn, rents may finally be bouncing on the bottom and Phoenix may be within 24 months of modest rent increases.

Currently, average Phoenix office rents sit at $22.30 per square foot, which compares to $24.31 during the same time in 2009 and $26.69 during the same time in 2008. In the most desirable Phoenix office districts, such as downtown Phoenix and the Camelback Corridor, average rents still sit as high as $27.20 per square foot. In further out, non-freeway-facing suburban sites, rents average closer to $20 per square foot.

The catalyst for rent growth (and an increase in office occupancy) still remains linked to jobs. At present, the Phoenix unemployment rate is just shy of a staggering 10 percent. And while some sectors, such as the plagued construction market, have shown employment stabilization, opinions remain mixed as to when job growth will gain real momentum. When Phoenix can place a marker indicating positive job growth, it’ll have a commercial office industry that’s poised to grow back very quickly.

According to an expert brokerage study on 20-year trends, the trigger for new office development in Phoenix appears to be a vacancy rate approaching 16 percent. Historically, and in almost every cycle, this is the rate the market requires to justify new office development. Phoenix, which sits at an approximate 25 percent overall office vacancy rate, still has a significant gap to fill. However, with no new inventory and stable absorption underway, this market may have moved out of reverse and into a slow and positive evolution.

Unfortunately, many office investors remain on the sidelines. Those that are actively buying are doing so with distressed sales that tend to drive values down. In reviewing all significant Phoenix office transactions (100,000 square feet and above) in 2010, not one was a true “arms-length” deal. On the upside, there are transactions in the pipeline that are expected to close this year and put bona fide sales back on the rolls. Moving forward, transaction volume and quality are expected to improve, though they may not do so until the market moves closer to a new development cycle, which is anticipated to begin in major submarkets no earlier than 2015 or 2016.

In the meantime, the Phoenix office sector can look forward to metered front-side recovery. A key benchmark to watch for will be a tightening of big-block availability, first in high-density labor locations along suburban freeways and also in the core markets. Thanks to the halt of new office construction, larger tenants whose leases expire before 2015 may find their options limited when their time comes, which in itself will trigger a build-to-suit market as early as 2012 to 2013. In the short term, any proliferation of new space, particularly in next 12 months, will likely be for government uses. This includes the DEA, VA and ICE, which are all actively acquiring space for expansion.

Expect a repeat of the third quarter for the ultimate quarter of 2010, with Phoenix office fundamentals remaining neutral across the board. This means no rent drops or increases, and vacancies that are stable and close to topping out. This will be a baseline for stabilization and a point from which Phoenix can focus on an improved horizon.

Don Mudd and John Bonnell are managing directors in the Phoenix office of Jones Lang LaSalle.

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