Secondary markets, primarily in the U.S. Sunbelt, are undervalued and set to outperform Gateway markets due to strong office-using job growth, rising rents and muted new construction, according to Cushman & Wakefield Americas Capital Markets research.
Overall, rent growth in secondary Sunbelt markets is 4.5% year-over-year through midyear vs. 3.2% rent growth for Gateway markets. Similarly, office rent growth is projected at 2.6% through 2019 for secondary Sunbelt markets vs. 1.3% for Gateway markets, mirroring projected office-using job growth of 2.3% for secondary Sunbelt markets and 1.1% for Gateway markets.
Secondary Sunbelt markets also have been absorbing office space at 3.3% of the average inventory over the past eight quarters compared to 1.7% in Gateway markets. As a result, vacancy in these markets has fallen, while vacancy in the six Gateway markets has risen 72 basis points (BP) since bottoming out in 2015. The spread between Gateway and secondary Sunbelt market vacancies has shrunk to 240 basis points, the lowest point this century.
Despite converging vacancies, however, rent spreads between Gateway and secondary Sunbelt markets remain near record highs at $21.90 per square foot (psf), well above the long-term average of $15.94 psf. Rent spreads have begun to narrow, though, as rental-rate growth in Sunbelt markets now outpaces Gateways. In secondary Sunbelt markets, the fastest rent growth is occurring in Nashville (9.9%), Austin (8.7%), Baltimore (8.3%), Miami (6.5%) and Phoenix (5.8%).
“Reflecting these strong fundamentals, investment capital is shifting to secondary office markets, where properties are generally undervalued,” said Noble Carpenter, Cushman & Wakefield President, Capital Markets, Americas. “Gateway market office volumes peaked in 2015 and are now declining, while secondary Sunbelt office market investment sales volumes continue to rise. We project these trends will continue through 2019.”
Secondary Sunbelt markets seem poised to outperform on fundamentals while they are significantly undervalued relative to Gateway markets. According to Real Capital Analytics’ Commercial Property Price Index, Gateway office prices were 70% above their previous cyclical peak as of June, while secondary markets are 8% above their previous peak. This is at a time when the construction pipeline in secondary Sunbelt markets is 1.3-times the annual average absorption of the past three years, compared to Gateway markets’ pipeline that is 3.3-times the annual average absorption over the same period.
“Secondary Sunbelt markets continue to offer highly attractive yields on a risk-adjusted basis, with upside from further cap rate compression at a time when many asset classes, particularly Gateway-market office, are fully valued,” said David Bitner, Cushman & Wakefield Senior Director and Head of Americas Capital Markets Research. “We see a wave of investment opportunity in secondary office markets, particularly with suburban assets, which have stronger momentum and have been less picked over by investors so far in this cycle. Since 2010, 72% of CBD office inventory has traded, compared to 65% in the suburbs.”
Dallas, Houston, Charlotte, Atlanta, Miami and Phoenix are the largest, most liquid Sunbelt markets, each with transactions volumes exceeding $1 billion in the first half of 2017. Of these, Houston (+293%), Charlotte (+79%) and Phoenix (+68%) have seen the greatest growth in volumes over the first half of 2016.
Cushman & Wakefield has developed a model to identify top markets positioned for material, fundamental improvement and that will remain attractively priced for the next two years. The model tracks metrics such as projected office-using employment growth, year-over-year vacancy change, overall asking rent, overall asking rent growth momentum, net absorption momentum, supply pipeline relative to absorption, inventory turnover and weighted average transaction cap rate over the past eight quarters. Seven of the top 10 markets are secondary Sunbelt markets, including Las Vegas; Baltimore; Sacramento, Calif.; Orlando; San Antonio, Texas; Phoenix; Inland Empire, Calif.; and Norfolk, Va.