By Ken McCarthy, Principal Economist
The U.S. seems to overbuild just when the economy turns down, leading to a glut of space that takes time to work off. We saw it in 2008, in 2001 and, most dramatically, in 1991, when the overbuilding was so substantial it took almost five years to work through. It happens every time, or so it seems. The commercial real estate industry is one of the most dramatically cyclical in the economy.
Now here we are early in 2018 in an economic expansion that is now almost nine years old and shows no sign of stopping, and there is a surge in new construction. On the face of it, it looks like the industry is headed toward the same over-building mistake. At the end of 2017, Cushman & Wakefield reported 103 million square feet (msf) of office space under construction in the 87 markets we track. In addition, 54.7 msf of office space was completed in those markets in 2017, meaning the total amount of space to be delivered from 2017 to approximately 2020 could exceed 150 msf.
At first blush, this seems like a huge pipeline, and, indeed, if it was all dumped on the U.S. market tomorrow, it would push the vacancy rate up by 280 basis points, bringing it back to the level of late 2012. However, there are balancing factors. The new supply will be completed over a period of at least three to five years, and while the new office space is being completed, jobs to fill at least some and probably most of that space are expected to be created. Cushman & Wakefield estimates that employment in office-using industries will increase by more than 1.0 million jobs over the next three years. In addition some of the new construction, is buildings that have been taken out of inventory and are being redeveloped. These are not net new additions.
Finally, although the numbers are large, the amount of new office construction was actually much larger in the mid-2000s and the late 1990s.
It’s All Relative
In 2017, total private sector spending on office construction of all kinds (including renovations) reached a record $60.7 billion according to the Census Bureau. That was well above the peaks reached in both 2001 and 2008. However, there has been a steady increase in the cost of construction over the past two decades as both material and labor costs have risen substantially. If construction spending is adjusted for rising construction costs, the amount of bricks and mortar actually built was far smaller than in either 2001 or 2008. In fact, the total amount spent by the private sector on new office construction in 2017 was more than 32% lower than in 2000 (see Chart 1).
Office Construction Put in Place
These national spending numbers correspond with the new office space completions tracked by Cushman & Wakefield. The 54.7 msf delivered in 2017, while well above the levels of a few years ago, was also far below the office deliveries recorded in 2008 and the 2001 level.
U.S. Office Space Completed by Year
Relative to inventory, the amount of new construction is even smaller. In 2001, office deliveries represented 2.9% of total inventory. In 2017 it was only 1.0%.
The first point to keep in mind about this flood of new construction is that the amount is not as large as in past cycles. Despite the worries, office construction has been comparably restrained.
Some Markets More Affected than Others
All real estate is local, so it is important to understand which markets are the most affected by new construction and which are best able to absorb it. At the end of 2017, 70 of the 87 markets tracked by Cushman & Wakefield had office space under construction, down from 73 markets a year earlier. But only a few markets have enough construction to have a major impact on local market conditions. The top 15 markets for new construction account for nearly 60% of the office space under construction.
Unsurprisingly, these cities have also been among the strongest throughout the current economic expansion, accounting for roughly one-third of all the U.S., office-using jobs created since the beginning of 2010. Demand growth has been strongest here so it’s no surprise that supply growth has been large as well.
Where Is the Construction?
Across the U.S., square footage under construction represents 2.0% of national inventory (see chart 4). However, there are a dozen markets where new construction as a percent of local inventory is above the national average, led by Brooklyn (8.5%) and San Francisco (8.3%). But most of these markets have already seen substantial pre-leasing, with the notable exceptions of Nashville and Denver. In addition, vacancy in every one of these markets except Denver is below the national average. So the markets with the most new construction for the most part have healthy underlying fundamentals, suggesting that the new construction can be absorbed. The increase in inventory in these markets is likely to have an impact on vacancy unless there is enough job growth to absorb the new space. The vacancy will mostly be in the existing Class-A stock as the pre-leasing data indicates that tenants are moving to the new construction.
New Construction’s Biggest Local Impact
Jobs, Jobs, Jobs
In the end the, the key driver of office space absorption will be jobs. If job growth remains healthy, markets with substantial new construction should be able to absorb it.
Eleven of the 12 high-construction markets have added office-using jobs at a much faster pace than the nation as a whole during the current expansion, suggesting that they are able to absorb the new construction.
|New York City*||23.0%|
*NYC is the city not MSA
Even though the numbers are high, new office construction has been relatively constrained in the current cycle compared to previous cycles, and does not appear to be getting out of hand. The markets experiencing the largest volume of new construction tend to be the healthiest in the nation in terms of both jobs and office fundamentals. In addition, many of these markets need new construction. In New York, Washington D.C., and San Francisco, new office stock is a welcome addition to an aging and less globally competitive inventory of buildings.
This is not meant to suggest that we should ignore the wave of construction. It is a large volume and a downturn in demand that would leave many markets with substantial vacancy. And even if the economy remains healthy, several of these markets will likely see an increase in vacancy in the short-term as they digest the new product.
At some point, the economy will soften and the real estate down cycle will be felt. It always is. But the markets that are experiencing the most new construction are also among the healthiest in the nation, which suggests that the next down cycle, when it does come, will not be as severe as some of the past real estate cycles.
Ken McCarthy has been with Cushman & Wakefield since August 2006. As Principal Economist, he works with the Chief Economist on Cushman & Wakefield’s U.S. economic position and presents it to the public. As Applied Research Lead, Ken is responsible for preparing cutting edge research about the outlook for commercial real estate in the Americas.