The Phoenix Valley office market continues to trek up the long road to pre-recession levels. With vacancy continuing its slow but steady decline, and absorption continuing to post positive numbers, the sector seems to have stabilized from its low point. The previous year, 2012, boasted the highest leasing activity in several years and hopes are high that the trend will continue well into 2013. The market is beginning to see a noticeable increase in large users, including the announcement by State Farm Insurance of a 1 million SF headquarters campus to be built on the south side of Tempe Town Lake, expected to bring over 5,000 employees. In addition, Governor Brewer announced several promising Valley expansions that could result in over 2,000 new jobs in the next 3 years; 600 new jobs coming to Scottsdale through ZocDoc, 1,000 high tech jobs with the General Motors IT Innovation Center in Chandler, over 300 new jobs in Glendale with Zytech Building Systems, and approximately 250 mortgage professional jobs in Tempe with Union Bank. As the Valley continues to be a hot spot for companies looking to expand, the market should expect to see exponential improvements.

Overall vacancy fell slightly this quarter to 20.4% from its 20.6% rate at the end of 2012, down substantially from Q1 2012 when the vacancy rate was 22.4%. Class A office vacancy continued to decline to a rate of 20%, a significant decrease year over year; Q1 2012 posted a vacancy rate of 23.8%. Class B spaces are also moving in a positive direction, resulting in a vacancy rate of 21%, down from 21.3% at the end of 2012, and down considerably from Q1 2012 at 22.6%. Class C continues to remain stagnant, with vacancy rates increasing slightly to 17.2% this quarter, up from 17.1% from the end of 2012, and rising from the 16.4% rate seen at the beginning of 2012.

While absorption figures remained positive for the first quarter of 2013, total net absorption is down significantly from the impressive Q4 of 2012. With 195,034 SF of net space absorbed this quarter, 226,281SF consisted of Class B office properties, while Class C properties continued to post negative numbers with -50,777 SF of net absorbed space. This trend remains visible as tenants are taking advantage of the market to leave lower grade properties while rental rates remain low.

Despite positive news in vacancy, leasing activity lagged this quarter with 1.6 million SF leased so far this year, the lowest first quarter seen in 5 years. This number is down since the end of 2012, when over 2 million SF of office space was leased in the final quarter. As new large users begin to take advantage of the currently low rental rates it is anticipated that the next several quarters will see an uptick in activity due to these newly signed long-term leases.

Rental rates fell slightly this quarter after three quarters with relatively no change. Q1 posted an average rental rate of $19.68 PSF, compared to the $20.04 PSF exhibited for most of 2012. Class A space rental rates remained flat at $23.16 PSF, while Class B fell slightly to $18.48 PSF after stabilizing at $18.96 PSF over the last three quarters. Class C space fell to $14.01 PSF after three quarters at $14.52 PSF.

It is anticipated that the progress of 2012 will continue into 2013; with absorption stabilizing and vacancy rates continuing to decline, rental rates should begin to improve as the market shows signs of recovery. While a fully sustained recovery in the office sector is still years away, economic conditions in the Phoenix area are continuing to improve at a faster pace than most metro areas in the US.

After a long struggle to regain ground, the Phoenix Office Market ends 2012 with record absorption numbers and falling vacancy. Office sector employment steadily increased throughout 2012 in the Valley, aiding in the recovery of the wounded market. Improvement should be expected to continue into 2013, as the local housing market continues to improve and businesses move away from the uncertain pre-election period. The pace of improvement will likely be moderate compared to the sharp increases seen in the final quarter of 2012.

Total net absorption was the stand out of Q4 2012 with 1,582,903 SF absorbed, a level not seen in over five years. This notable increase helped mark 2012 as the first year since 2006 to post positive absorption numbers for all four quarters, ending the year with 3.25 million SF absorbed. Vacancy also headed in a positive direction falling to 20.4% for Q4, down from the 22.3% seen in the beginning of 2012. This decrease in vacancy is a hopeful sign for the future; vacancy levels have not been this low since the beginning of 2009, and peaked at 22.8% mid-year 2011.

While the record year of space absorbed leads the market strongly into 2013, a considerable percentage of this was due to a handful of large users and may not reflect all submarkets fairly. Tenants such as State Farm, QBE Insurance, and U.S. Foods absorbed close to 600,000 SF alone in 2012, making up almost 20% of the year-end total. As consistency is regained in the office market, the positive absorption figures can expect to even out among tenants in varying sizes and submarkets.

Somewhat clouding the positivity seen in absorption and vacancy figures was the continued decline in rental rates. It has been a long and steady decline from the $25+ PSF rates seen in 2007 and 2008; rental rates began in Q1 12 at $20.24 PSF, dropping to $20.07 PSF for both Q2 and Q3, and ending the year at $20 PSF. While vacancy rates are on the decline, they still remain at historical highs, leaving rental rates depressed until more competition for space occurs in the Phoenix Metro market. This has left considerable room for tenants to benefit from the lower rates and greater concessions, making it unlikely for rates to grow substantially.

Leasing activity declined in the second half of 2012, most likely due to decision halts in anticipation of the fiscal cliff. The second quarter of 2012 peaked with 624 lease completions and 2.6 million SF leased. The year ended with Q4 posting 500 completed leases and just 1.4 million SF leased. As the fiscal cliff is resolved, business activity should return to previous levels and the positive effects of job growth will begin to trickle down to the commercial real estate market.

The Phoenix Office Market trudged along during the third quarter with mediocre growth. The Coincident Index for Phoenix, which includes four indicators: nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing, and wages and salaries, increased during the third quarter from approximately 179 to 180.5. Another measurement of job growth that has impact on the Phoenix office sector is the Professional and Business Services Employment rate. According to the Bureau of Labor Statistics, the number of individuals employed in Arizona in these fields increased to approximately 348,000 from 355,000 during the third quarter.

The third quarter recorded positive absorption at 467,529 SF, marking a 22% decrease from the 570,000 SF absorbed in the second quarter. The Tempe and Central Scottsdale submarket posted the highest positive absorption figures at 219,820 SF and 158,417 SF, respectively. The Deer Valley submarket recorded the highest negative absorption figures, with (8,879) SF of space. This movement is consistent with recent trends; tenants are continuing their flight to higher quality space driven by accessibility. According to data, such Class A properties are being met with the highest demand.

Square footage leased totaled 1.6 million SF this quarter, compared to the 2.6 million SF recorded in the second quarter. Sales data recorded an even larger downfall; the total dollar volume of sales declined nearly 80% to $25.33 million. The top lease transactions during this quarter included: the 139,404 square foot lease at 4500 E Cotton Center Blvd in Phoenix signed by Aetna, the 138,240 square foot lease at 444 N 44th Street in Phoenix signed by State Farm Mutual Automobile, and the 105,000 square foot lease at 2222 W Dunlap Ave in Phoenix to United Healthcare.

The office vacancy rate declined slightly during the third quarter to 20.0%, an improvement from the second quarter rate of 20.2%. However, the slight improvement in vacancy did not translate to increased rents. Rental rates are still being priced by tenants; demand is not strong enough for price increases to take effect. Rental rates in the third quarter dropped to $20.18 per SF from $20.20 in the second quarter. The supply of vacant space must still be worked through for rental rates to trend up.

Office building construction matched the low levels seen during the second quarter. There were no new construction starts this quarter, and only 55,617 SF of space was delivered. There is currently 374,390 SF of space under construction. On a positive note, the final phase of Hayden Ferry Lakeside, a Class A office tower in Tempe, will potentially begin construction in the future quarters. This project has been stalled since the recession began and marks the first anticipated high-rise to break ground in Tempe since 2007.