The Las Vegas commercial office market continues to be impacted by national instability as well as a local market that is facing its most significant supply-demand imbalance in recent history. At the national level, softening fundamentals and a financial market in crisis have slowed new business development to a crawl and put several business expansions on hold – a challenging condition for a market that has become accustomed to absorbing 2.4 million square feet per year during the past five years. Fundamentals in Las Vegas provide little in the way of a safe harbor, as layoffs continue, foreclosures lead the nation and consumers appear content to reside on the sidelines. Although we believe that Southern Nevada’s office market will face its most challenging test in the months to come, we remain optimistic about the market’s mid-term prospects.
From an office demand perspective, economic growth continues to slow, witnessed by the latest national employment and gross domestic product figures. During September 2008 (latest available national data), non-farm payrolls experienced its largest decline since March 2003, a condition that has many firms responding cautiously with a limited amount of office expansions and/or relocations. The latest employment declines were well beyond the market’s expectation of 105,000 (Dow Jones Newswire Survey) and suggest the national economy is headed into a significant recession.
The latest financial crisis and subsequent Wall Street bailout package has the market seesawing, with little confidence that Congress’ actions will have any immediate impacts much less quell broader concerns about the economy.
While national conditions have the potential to impact the Las Vegas office market performance, local economic conditions remain an overriding consideration. Local economic declines are led by a particularly weak housing sector. Nevada currently ranks near the top of the nation in terms of residential foreclosures, housing starts are at 20-year lows and prices are back to 2003 levels. Residential market layoffs and declines in purchases and production has rippled through the economy. Consumers are spending less than they were one and two years ago. Unemployment levels are above seven percent and employment growth remains negative from the prior year. Business owners are manifesting their challenges with softer earnings reports for public companies and staffing reductions and reorganizations by several private firms. The full effect of the current financial crisis on national and local economies is at best unclear. That said, it is hard to imagine how the office sector avoids a fate similar to that of the residential sector during the next 18 months without a sharp turn in local economic conditions.
Latest Office Market Performance
By the close of the 3rd Quarter of 2008, the Las Vegas office market reached new heights in terms of vacancy. With nearly 8.2 million square feet of available space and a market inventory of 48.0 million square feet, vacancy levels reached 17.0 percent as of September 30, 2008. Compared to the national office market picture, Las Vegas reported elevated capacity as national vacancies hovered around 12.0 percent and are expected to rise to 14.4 percent by mid-2009 (National Association of Realtors). We are looking for vacancy rates to approach if not surpass 20 percent before stabilizing.
Availability represented a slight increase from the 16.8 percent reported in the preceding quarter (2nd Quarter of 2008) and was up 3.8 points from the 13.2 percent vacancy factor one year ago. During the past two years, vacancies climbed by 6.7 points from 10.3 percent and from the low-point of 8.2 percent in the 3rd Quarter of 2005, vacancies have more than doubled.
Age of product plays a key role in the average vacancy rate. Office buildings completed during 2008 reported an average vacancy rate of 56.5 percent, with Class A product built during the year posting a 68.4, percent vacancy factor. Those figures reduced to 29.3 percent and 19.3 percent, respectively, for product constructed during 2007. Buildings developed just five years ago (2003) posted the lowest overall vacancy rate of 6.9 percent and all product construction prior to 2000 reported an average vacancy of 11.9 percent. Absorption of newer product will be required before the market-wide vacancy begins to improve.
During the 3rd Quarter of 2008, the market reported 651,400 square feet of new supply located in 19 projects.
The bulk of new product was classified as Class B, comprising 552,500 square feet, while approximately 98,900 square feet of Class A product was added to the market. From a geographic perspective, completions were concentrated in a few key areas within the urban valley. The south and southwest submarkets continue to report the largest segment of new supply representing a combined 63.3 percent of all new construction. The northwest portion of the Valley also reported new supply with approximately 107,100 square feet of product, while the north submarket reported 88,900 square feet of completions.
Through the first nine months of 2008, there was a total of 2.6 million square feet of completed construction; new supply levels are well off the 3.7 million square feet reported during the calendar year of 2007. During the past decade, the market posted an annual average expansion of 2.3 million square feet.
In addition to space recently completed, a number of projects remain in the development pipeline. At the close of the 3rd Quarter of 2008, approximately 2.6 million square feet was under development. Major projects include the following:
• Rainbow Sunset Pavilion – A 226,140-square-foot building located in the southwest portion of the Valley and adjacent to the Boyd Gaming Corporation flagged-structure;
• Tivoli Village at Queensridge – Approximately 200,000 square feet of space is underway at the mixed-use project located at Rampart Boulevard and Alta Drive;
• Summerlin Centre – A 9-story building located within the Summerlin mixed-use project recently topped off and is expected to comprise 200,000 square feet of Class A product;
• Montecito Point – Another multi-story building located in the northwest at the intersection near Durango Drive and Interstate 215 is expected to offer 186,300 square feet of space with views of the Las Vegas Valley;
• Windmill Office Plaza – A multi-building project located at the northeast corner of Windmill Lane and Placid Street;
• Copper Pointe Business Park – A two-building project located in the southwest submarket at Interstate 215 and Patrick Lane.
Despite the above-average vacancy rate in the southwest submarket, the area continues to report the largest share of development activity with 1.1 million square feet underway, representing 44 percent of Valley-wide construction. The northwest area also reported a sizeable share of construction (659,500 square feet) representing 25 percent of the market total. Other activity is located in the south, southeast, central/north and north market areas.
While a number of projects are moving forward, under-construction activity is at its lowest level since mid-2005. Additionally, plans for another 4.3 million square feet remain on the drawing board. However, given the current environment in the financial and commercial markets, we expect many of these project proposals to either shift timing, scale-back plans and/or shelve the projects altogether. Those with quality designs, competitive price points and access to quality amenities will continue to fare better than less competitive product in the market.
Throughout the 3rd Quarter of 2008, the market demanded (absorbed) 457,500 square feet of space, which represented the largest quarterly total since the 2nd Quarter of 2007. Leasing incentives and competitive pricing in newly constructed buildings allowed several deals to move forward during the quarter. While only a modest share of space that entered the market during the quarter was pre-leased (37 percent), demand for buildings that completed construction during the past two years was much higher. A total of 566,900 square feet was demanded (net) in buildings that completed construction during 2007 or 2008. Positive demand for these buildings was offset by net outmigration in older office product.
Nearly all of the market demand (95.4 percent) during the quarter was concentrated in Class B product, with medical buildings representing a notable 52.5 percent of market-wide net absorption during the quarter. Professional buildings comprised 36.6 percent of demand, while a few government buildings experienced a modest level of demand, including the recently acquired Atrium Business Center by the City of Las Vegas.
The market continues to demand product in business park environments (multiple buildings) with supporting retail amenities in the area. Transportation and access to major thoroughfares is also key for many of the more successful developments.
Average asking rent growth continued to decelerate given the current environment as pricing pulled back to $2.36-per-square-foot on a full service gross basis. The latest indicator reflects a $0.02 decline from the preceding quarter (2nd Quarter of 2008) and is flat with the same quarter of the prior year. For comparative purposes, national rent growth is expected to average 3.2 percent in 2008 and 0.4 percent in 2009 (National Association of Realtors).
Areas reporting above average asking rents include downtown ($2.69/SF), the southwest ($2.49/SF) and the south ($2.6/SF) submarkets. The lowest average asking rents were reported in the central east submarket, despite the premium-priced Hughes Center located within the area.
Average reported rents continue to be impacted by the mix of available space and may also reflect a disconnect with actual achieved rents on lease deals completed. We also noted increased concession activity with free rent periods being offered as a measure to entice tenants to relocate and/or expand. Elevated tenant improvement allowances continue to be offered on newly constructed space, while incentives exist on second-generation product as well. Based on discussions with developers, it appears costs for tenant build-outs have become much more competitive and allowances have been sufficient to accommodate typical tenant build-outs.
Soft conditions are expected to prevail in the office sector for the next 12 months, with our absorption projections being reduced 20 percent through the 3rd Quarter of 2009. As noted earlier, vacancies have the potential to edge up toward 20 percent Valley-wide, while areas such as the south and the southwest submarkets will experience vacancy rates well beyond that figure as new projects face extended lease up periods and existing products face stiff competition on price particularly with cost conscious tenants.
From a supply perspective, we anticipate a deceleration in the level of construction completions during the course of the next six to eight quarters. Significant supply additions during the past two years will compete for the majority of market demand, while pre-leasing activity in speculative stand-alone buildings will be much more challenging.
Demand for product will likely ebb and flow with the Southern Nevada business cycle. Competitive pricing will be a competitive advantage for projects that have the ability to cut pricing to spur demand. Also in the near term, bank repossessions may become more prominent and begin to further impact pricing. Opportunities for tenants will emerge where the cost of relocation will be outweighed by competitive pricing and sufficient concessions.
Looking at the three to five year range, we expect a much more balanced environment to prevail as product in the pipeline today will have completed construction and begin to benefit from an improving economic climate. The development timeline of sizable projects may create a void in the new construction segment by 2011, a period when fundamentals should be more favorable. The 27,000 hotel rooms that are currently under construction are expected to provide yet another boost to the Southern Nevada economy. Employing upwards of 50,000 leisure and hospitality positions during the next three years, indirect impacts, including those in the professional and business services segment, should be prominent.
The difficulties of the present economic climate cannot be overstated. Southern Nevada has had one of the most robust office markets in the nation during the past decade, arguably adding and absorbing more new space than any community of its size in the nation. Today, however, development continues at a brisk pace even as the market fundamentals counsel otherwise. This trend will only exacerbate the current supply-demand imbalance in the coming months, putting increased pressure on existing operators to cut costs and prices and placing some projects into severe financial hardship. The potential impact of this reality on local financial institutions is also material and worth monitoring during the next three to four quarters.