Office Market: National Cap Rate Trends
The office market saw a significant jump in the second quarter to a national average cap rate of 7.5%. Office cap rates have seen far more volatility than apartment cap rates, as the chart below shows. The average peaked at 7.5% in the first quarter of 2016 (as well as in the third quarter of 2017) before falling to a recent low of 6.3% in the first quarter this year. We caution that this volatility is generally indicative of selection bias, represented by the disparity in the properties that traded in the last few quarters.
Note in the 12-month rolling average trend how office cap rates had increased in 2017, but have trended lower over the last two quarters. Also note that the rolling average saw no change in the second quarter at 7.0%. The rolling average office cap rate is 20 basis points lower than it was one year ago.
One could argue that the increase in the office cap rate in 2017 reflected the Fed’s monetary tightening. It also reflected sluggish quarterly office effective rent growth. It is possible to look at the numbers and conclude that first quarter drop in the office cap rate was more of an anomaly and that the 7.5% rate in the second quarter is more in line with fundamental trends. Office rent growth increased a bit to an average of 0.75% in the last two quarters, but the overall vacancy rate was little changed at 16.6%, which is unusually high given how deep we are into the current expansion and how moderate construction has been compared to past cycles. Tenants are leasing fewer square feet per added employee and investors have generally not preferred this asset. That said, transaction volume decreased only slightly in the quarter, less so than in the apartment market.
Office Market: Cap Rate Trends by Region
Breaking out this national trend line by region, we see how cap rates by region have converged toward the national average trend.
After climbing considerably in 2017, office cap rates in the Southwest have declined, as shown in the green line. In the second quarter, the Southwest office cap rate fell to 7.1% – just above the national average. The other surprise in the data was the decline in the South Atlantic office cap rate to 7.2% from 7.4% last quarter. The South Atlantic volume accounts for 22% of the overall sales volume. As shown by the red line, the West saw an increase in its rolling average cap rate back up to 6.7% after falling to 6.4% in the previous quarter. The West was the only region that recorded an increase in sales volume in the second quarter, and it continues to have the lowest cap rates of any region. In contrast, the Northeast region saw no change in its office cap rate. As shown in the purple line, the Northeast region had the highest cap rate of any region in the second quarter at 7.5%. The rolling average office cap rate in New York City increased to 6.7% from 6.1% last quarter, but the increase was largely due to selection bias in that more class B/C properties traded in the quarter than in the previous quarter. Also, sales volume fell in the second quarter in the Northeast after increasing in the first quarter. Last but not least, the rolling average office cap rate in the Midwest was little changed in the quarter at 6.9%, just below the national average. Volume in the Midwest declined disproportionately more in the second quarter than in other regions.