By: Walter Bialas
As a quick review of our first and second installments on Dallas’ office market development, what we have concluded is that the current cycle is very different than the last two – and that is going back 20 years.
Today, our economy has vastly different drivers shaping our market. While our last cycle is instructive, it was not typical due to the much lower office construction delivered. This chart overlays net absorption and office construction as a percent of inventory. The last couple of economic cycles clearly stand out.
Dallas tends to not have deep periods of negative absorption like other markets around the country. Rather, we simply overbuild – and we tend to continue building in the face of declining demand because ambitious projects get started that must be completed.
We previously illustrated that the spec office buildings that came on line at the end of the boom fared pretty well. In fact, even though it may have taken two to three years for the properties to stabilize, they achieved respectable rents – and have remained fully leased with current rents well above their opening rates. The key factor was modest new construction / competition.
Today is different. With Class A & B office vacancy at 19.1%, we are tight by historic standards. It really does not matter that vacancy has inched up the last few quarters because we are still in good shape. What is telling, however, is that the development cycle is in full swing. Recently, we have been updating our list of projects under construction and soon to break ground a couple of times a week. As of Q1, under construction totaled 5.1% of inventory and by year-end, we will be a more than 8%.
Though we have several large built-to-suits underway, of those millions of square feet, only Toyota is new to our market. The other large projects will undergo consolidation throughout the region, similar to State Farm. This space will have to be back-filled – so all of the large-scale construction is not completely “net new” to our region.
Additionally, several of the new buildings that have kicked-off with pre-leasing to name-recognized, lead tenants are taking those users from existing properties. This space will also have to be back-filled. Add to that the complicating factor of users becoming more efficient – and we have probably 10 million square feet of true spec or essentially spec space coming to market in the near future.
While that spec number is big, we have not seen much spec space delivered in a long time, so there has been some increased demand and our anticipated demand over the next few years is sufficient to keep that supply and demand in balance. Based on our analysis, if only the current pipeline is developed, vacancy will remain around 20% by the end of 2019, a favorable amount showcasing continued tight market conditions.
Now even though there may be some imbalances between submarkets, with average vacancy remaining below our long-term benchmark, we will likely continue to build office space. Complicating this is the fact that the consensus sees the US economy going through a slowdown potentially in 2018. At that point, DFW will still look strong because we will be buoyed by the delivery of the large built-to-suits at that time in the cycle. As such, unless local market forces, capital markets, and the like exercise unusual restraint, new projects will continue to fill our pipeline and be initiated.
Currently, 20 million square feet of office space has been proposed. The gray dashed line highlights that potential new supply that could hit the market. Unlike previously when office construction remained modest, this time we could see a continued flow of office space into a national slowdown if our development engine becomes overly exuberant. What does this mean for Dallas market fundamentals? Forecasts like this are always tough, but if we build just half of that proposed pipeline – our average vacancy rate will reach 24% by the end of 2019.
Hopefully we will not get to this level because it is comparable to the overbuilding we saw at the end of the tech bust and even at the end of the last cycle, which it took a few years of solid demand to drive vacancy back down to levels where we saw good rent growth.