Economic and Market Outlook: SAN ANTONIO OFFICE Q1 2016

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1 Economic and Market Outlook: HOUSTON SAN ANTONIO AUSTIN Table 1. Key market indicators for Q1 2016, and their percent (%) change on a quarter-over-quarter (QoQ) and year-over-year (YoY) basis (Class A and B buildings combined). Percent Change over Prior Period Q QoQ (%) YoY (%) Asking Rent: Class A $ % 4.0 % Asking Rent: Class B $ % 1.8 % Net Absorption (sq. ft.) 198, % % Leasing Activity 395, % % Availability (%) 20.9% -2.8 % 4.5 % Vacancy (%) 16.1% 1.3 % 3.2 % Deliveries (sq. ft.) 322, % % Construction (sq. ft.) 406, % % Inventory (sq. ft.) 35,934, % 2.4 % Executive Summary The economic outlook has bounced back from January and February lows, but remains weaker than could be due to volatile financial markets and low prices of commodities. There seems to be a disconnect between Wall Street and Main Street, as Q showed turmoil and volatility on Wall Street, but there was strengthening confidence by the consumer on Main Street. With much talk of an economic recession, the Feds put the near-term probability at 10% and Wells Fargo is slightly higher at 25%. The outlook for Texas and San Antonio economies are similar, poised for modest growth. Employment in U.S. grew 2.0%, with San Antonio at 1.6%. Business growth in San Antonio was 5.3% in January, but dropping to a still positive 4.7% in February, the slowest but again still positive growth since early Net absorption was nearly 200,000 sq. ft. in Q1 2016, a demand for office space that is actually an increase above its historic Q1 performance. Yet, leasing activity in Q1 was only 395,085 sq. ft., significantly lower than historic Q1 levels. The sizeable net absorption kept vacancy from increasing substantially, leaving it at 16.1%. Availability declined slightly to just under 21%, stopping its upward trend toward historic highs near 22%. Office growth continues in San Antonio, with 322,000 of new deliveries and 400,000 remaining under construction. 1

2 Broker s Perspective We started out 2016 by seeing landlords motivated to offer aggressive economic packages. Last quarter new construction was quoted at a 20% premium over second generation buildings. This did not include any shortfall of tenant improvement allowances that would be the tenant s burden to bear. The observation that new construction had to close this gap to be competitive began to prove itself last quarter. From these new buildings we have seen lower rental rates, higher tenant improvement allowances, and increased rental abatement. In addition to more rounds of negotiation and due-diligence, these improvements occurred by informing the landlords what the market conditions were from the tenant perspective. Owners tend to run a few months behind what the true market conditions are, especially from the tenant perspective. Once owners realized where their building stood vis a vis other viable options, tenants are able to negotiate concessions that closed the gap between new construction and second generation buildings. A portion of this is also the landlords realization that the time to strike a deal is now. We expect to see more of this in the second quarter: landlords stretching to retain their existing tenants or lure new tenants. Clare Flesher Managing Director of San Antonio Office, NAI Partners We started out 2016 by seeing landlords motivated to offer aggressive economic packages. 2

3 ECONOMIC OVERVIEW The overall U.S. economic outlook has bounced back from January and February lows, but remains a bit weakened due to volatile financial markets and low prices of commodities. The outlook for Texas and San Antonio economies are similar, poised for modest growth. Employment in U.S. grew 2.0%, with San Antonio at 1.6%. Business growth in San Antonio was 5.3% in January, but dropping to a still positive 4.7% in February, the slowest but again still positive growth since early National Economy The overall economic outlook has bounced back from January and February lows, but remains a bit weaker than could be due to volatile financial markets and the low prices of commodities. Yet, there seems to be a disconnect between Wall Street and Main Street; while the first quarter of 2016 showed turmoil and volatility on Wall Street, there was strengthening confidence by the consumer on Main Street. With much talk of an economic recession, the St. Louis, Atlanta, and New York branches of the Federal Reserve Bank all put the probability of an economic recession at 10%, but Wells Fargo gives a higher 25% probability over the next six months. It is important to remember that more economic recessions have been forecasted than actually manifest. The U.S. gross domestic product (GDP) is projected to be 2.3% for 2016, a modest difference from 2.4% in GDP will continue to grow with pent up demand in the housing market and strong consumer spending, the latter of which accounts for about 66% of GDP. Although consumer confidence was down in the winter with stock market volatility, it increased 2.2 points in March to 96.6, but consumers continue to be frustrated with slow growth in income. Consumer credit increased for the 54th month in a row. Data indicate economic growth in Q1 with improving job market and lower debt burdens aiding private consumption. Yet, the strong dollar, volatile financial markets, and low commodity prices way down the overall positive outlook. Employment in March increased 215,000 jobs, with gains across many sectors, including in particular retail, health care, food services, and business services; again, the primary weakness in job growth remains with energy, manufacturing, and export industries. The ISM manufacturing index increased to 51.8 in March, indicating the first expansion in factory activity since August Nevertheless, hiring remains low in manufacturing. Unemployment increased to 5.0%, but this is likely attributed to workers re-entering the work force. There are likely to be two hikes in interest rates by the Fed, one in the summer and the other at the end of the year, due to modest economic growth and global uncertainties. Core inflation was 2.1% in 2015, and will likely rise to near 2.4% in 2016, which will also help the Fed justify increasing interest rates. International trade will continue to decline and hamper GDP with strong dollar (up nearly 20%) and global pullbacks, including in particular China and Brazil. The trade deficit is likely to increase 4% in In February the trade deficit increased 2.6% to $47.1 billion, the highest level in past six months. San Antonio and Texas Economy The outlook for Texas and San Antonio economies are similar, poised for modest growth. Employment in Texas, despite the energy pullback, grew 0.4% in February compared to U.S. at 2.0%, with 4,500 new jobs following 23,700 new jobs in January. Unemployment in Texas was 4.4% in February, still lower than U.S. level of 4.9%. Job growth in San Antonio while remaining positive slowed to 1.6% for three months ending February Job growth was broad across many sectors, excluding mining. The San Antonio Business Cycle Index of the Dallas Federal Reserve measures the San Antonio economy based on movements in local unemployment, nonagricultural employment, inflationadjusted wages, and inflation-adjusted retail sales. Business growth in San Antonio was 5.3% in January, but dropping to a still positive 4.7% in February, the slowest but again still positive growth since early

4 MARKET OVERVIEW Net absorption was in Q and Q have been solid gains indicative of strong demand for office space in San Antonio. While down from Q1 2015, Q was still a robust 198,000 sq. ft. However, leasing activity, another measure of demand, was 395,000 sq. ft., which is statistically less than the historic Q1 average of 561,468 sq. ft. Declining leasing activity suggests that coming quarters will see lower net absorption, as net absorption lags behind leasing activity. Office supply, as measured by vacancy and availability, remained steady, with availability at 21% and vacancy at 16%. Deliveries in Q were 322,315 sq. ft., increases of >200% QoQ and >2000 YoY (due to low 13,000 sq. ft. deliveries in Q1 2015), with another 406,000 sq. ft. still under construction. Class A and B space had stable asking rents, at $23 and $19, respectively. Net Absorption Demand, as measured by net absorption (direct plus sublease space), is the change in occupied stock inventory, including direct and sublet space. Figure 2 shows net absorption since 2006 by year and quarter for combined Class A and B office space. Positive net absorption of 198,807 sq. ft. occurred in Q1 2016, yielding a -24.6% decrease QoQ but a strong increase 1197% YoY given Q had negative absorption (Table 1). Leasing Activity Leasing activity, another measure of demand, is the total amount of space represented by direct leases, subleases, renewals, and pre-leasing of rentable building area. Figure 3 reports leasing activity since 2006 by year and quarter for combined Class A and B office space. Leasing activity of 395,085 sq. ft. occurred in Q1 2016, which represents decreases of -48.7% QoQ and -26.6% YoY (Table 1). The historic Q1 average (± 95% confidence interval) for leasing activity is 561,468 sq. ft. (± 81,753). We are 95% certain that Q1 leasing activity typically falls between 479,716 to 643,221 sq. ft. This indicates that current leasing activity is statistically lower than historic Q1 measures since With absorption lagging behind leasing, lower leasing activity in Q1 suggests lower absorption in quarters to come. Vacancy and Availability Vacancy and availability measure the supply of office space. Availability better measures total supply because it includes vacant, occupied, and sublease 4

5 space. Vacancy better measures empty space on the market, whether or not that space is leased or for rent. For Class A and B buildings combined, availability was 20.9%, down 2.8% QoQ, but up 4.5%% YoY (Table 1). Likewise, vacancy was 16.1%, up 1.3% QoQ and 3.2% YoY (Table 1). Overall, office supply remained relatively stable in Q1 2016, compared with recent quarters (Figure 4). Asking Rent Figure 5 plots asking rent for direct and sublease space since 2006 for each of Class A and Class B buildings. In Q1 2016, both Class A and B space showed stable direct asking rents, with Class A asking rent at $24 and Class B at $19. However, asking rents of sublease rents for both Class A and B are on a downward trend. Construction and Deliveries Construction of new RBA is an important variable shaping the supply of office space. RBA delivered refers to completed construction, while RBA under construction refers to space under construction that has not yet been completed. As detailed in Figure 6, deliveries in Q were 322,315 sq. ft., increases of 217% QoQ and 2239% YoY (Table 1). Such YoY percent change results from there only being 13,000 sq. ft. of deliveries Q RBA under construction was 406,418 sq. ft., decreases of -44.3% QoQ and -54.6% YoY (Table 1). Inventory Figure 7 depicts changes in the inventory of Class A and Class B buildings since 2006, both in terms of RBA and the number of buildings. RBA inventory for Class A and B office space included 35 million sq. ft. for 828 buildings (Table 1, Figure 7). Note, only 90 of these buildings are Class A buildings, and of the Class B buildings, about 50% are <20,000 sq. ft. in size. Stock inventory is up 2.4% YoY. 5

6 Select Largest Deliveries Building Name Building Address Percent Leased Submarket Name 8554 Huebner Rd 8554 Huebner Rd Northwest 0% WestRidge Two at La Cantera La Cantera Pky Far Northwest 0% Ridgewood Parkway Ridgewood Pky Far North Central 32% Stone Creek Center #2 226 N Loop 1604 E North Central 0% Select Sales Property Address Sale Date Sale Price Price Per SF 950 Isom Road #105 01/15/2016 $2,300, $ Soledad Street 01/21/2016 $3,000, $ Fredericksburg Rd 01/22/2016 $1,536, $ Barlite 01/29/2016 $6,056, $ E Evans Road 02/02/2016 $1,250, $ Pleasanton Road 02/16/2016 $618, $ W. Rhapsody 02/22/2016 $560, $ Medical Drive 02/24/2016 $13,750, $ Louis Pasteur Drive 02/24/2016 $2,765, $ Interstate 10 E 03/01/2016 $924, $ West Avenue 03/01/2016 $580, $ Stone Oak Parkway 03/11/2016 $3,700, $ E Quincy St 03/17/2016 $457, $ Gulfdale Street 03/18/2016 $2,125, $ Copeland 03/21/2016 $150, $ Isom Road 03/22/2016 $1,835, $80.79 Under Construction Building Name Building Address Rentable Building Area Submarket Name Landmark One Anthem 164,351 Northwest Vista Corporate Center IH-10 W 150,735 Northwest Huntington West, Phase I 3424 Paesanos Pky 48,000 North Central Gold Financial Building 2910 N Loop ,000 North Central Select Major Lease Transactions Tenant Building Square Feet Atento* University Park Tech Center III 36,653 Bury, Inc. 70 NE Loop ,727 URS 112 E. Pecan St. 13,062 * Renewal 6

7 Class A Market Statistics Existing Inventory Vacancy Under Quoted Market # Blds Total RBA Direct SF Const SF Rates CBD 9 2,242, ,595 0 $25.47 Far North Central 15 1,780, ,619 0 $26.83 Far Northwest 5 785, ,015 0 $26.00 Far West 12 1,212, ,032 0 $19.33 North Central 32 4,032, ,489 76,000 $24.95 Northeast 8 959, ,325 0 $25.49 Northwest 26 3,901, , ,086 $22.64 South 1 80, $17.12 Class B Market Statistics Existing Inventory Vacancy Under Quoted Market # Blds Total RBA Direct SF Const SF Rates CBD 88 4,660, ,934 0 $18.68 Far North Central 130 2,599, ,067 6,000 $22.01 Far Northwest ,613 3,000 0 $22.41 Far West 48 2,858,161 86,005 28,000 $19.25 North Central 367 8,124, ,780 3,062 $20.17 Northeast 90 3,437, ,302 0 $18.59 Northwest ,061,833 1,490, ,158 $18.45 South 62 1,536, ,634 16,000 $18.36 The San Antonio Office Sub-Market Map 1. CBD 2. Far North Central Far Northwest 4. Far West 5. North Central 6. Northeast Northwest 8. South Methodology This office market report includes information and data for multi-tenant Class A and Class B buildings, but does not include Class C buildings. 7

8 Economic and Market Outlook: Marketing & Research Team J. Nathaniel Holland, Ph.D. Steven Cox Nuance Stone Chief Research and Data Scientist Director of Property Research Sr. Director of Marketing and Research Information and data within this report were obtained from sources deemed to be reliable. No warranty or representation is made to guarantee its accuracy. Sources include: U.S. Bureau of Economic Analysis, CoStar, Council on Foreign Relations, Federal Reserve Bank of Dallas, FiveThirtyEight. com,moody Analytics, NAI Global, National Association Realtors, Texas A&M Real Estate Center, Well s Fargo, University of Houston s Institute of Regional Forecasting, U.S. Bureau of Labor Statistics. HOUSTON SAN ANTONIO AUSTIN 85 N.E. Loop 410, Suite 418 San Antonio, TX tel