Economy:
It has been a healthy first nine months of the year in the Kansas City commercial real estate market. On the office side, absorption has remained positive and earlier this year ground was broken on the largest new office project in more than a decade. For industrial, all signs have continued to point towards a new period of expansion. While office and industrial have had little in common over the past decade, one trend has become clear for both: older space has struggled. Class B office space continued to lag behind Class A, and older warehouse buildings have failed to backfill space vacated by tenants moving into new construction.
Looking at the broader economy, one cannot ignore that inflation remains a primary concern. The Federal Reserve Bank of Kansas City publishes a monthly survey on manufacturing activity in the Tenth Federal Reserve District, and it includes a “Selected Manufacturing Comments” section. While there are examples of growth and optimism about the near- and mid-term future, every monthly report also cites increased costs, an inability to support wage growth, and genuine fear about energy costs and economic policy. The regional economy has remained resilient, and there are positives to be found, but it is clear that fundamental economic threats remain.
Market Overview:
In many ways, the third quarter summed up the recent trends in the office market. Class A product saw positive absorption of 162,000 square feet (sf), which pushed the year-to-date (YTD) total to 360,000 sf and the vacancy rate down to 16.6%. Unfortunately, Class B space reported negative absorption of 278,000 sf which was enough to flip the YTD figure negative and lift the vacancy rate to 20.1%. The split in performance has been ongoing and shows up in almost every statistical measure. At first glance, Class B space has been outperforming Class A in leasing activity, with 1.1 million square feet (msf) of new deals signed in Class B through the first three quarters compared to 900,000 sf in Class A. But
inspecting the ratio shows just how disappointing that figure is. So far this year, the ratio of Class B space leased to Class A space leased is 1.2 sf-to-1.0 sf, but the ratio of existing inventory is 2.1 sf-to-1.0 sf. This demonstrates leasing in Class A space is far outpacing leasing in Class B in an apples-to-apples comparison.
A more granular review of the data only reinforces the facts. Nine months into the year there were 37 buildings in the market that had reported negative absorption of at least 10,000 sf, of which 34 were Class B. The three Class A buildings had absorption totals of negative 11,000 sf, negative 12,000 sf, and negative 22,000 sf. In contrast, the Class B buildings averaged negative 27,000 sf per-building. In total, Cushman & Wakefield research tracks 13 different office submarkets and 12 of them have at least one Class B building with more than negative 10,000 sf of absorption so far this year (the one exception is Midtown, which has only 208,000 sf of total inventory). The Class B vacancy rate will improve as Cushman & Wakefield research completes a comprehensive review of the market and removes older, obsolete buildings with elevated vacancy, but that change on its own will not make the existing Class B space in the market more appealing to tenants.
This data does not mean tenants are disinterested in Kansas City office space. It demonstrates that there is a level of quality they are looking for and unfortunately at this time the local market is not providing that. Since the start of 2014 the market has seen the delivery of just under 3.0 msf of Class A space and the occupancy rate in those buildings was 97.4% at the end of the third quarter. Once again, a more thorough review of the statistics only reinforces the trend. Aggregated data on published asking rates can be misleading, but the 8.2 msf of office inventory with a published asking rate of $28.00-per-square-foot (psf) or more had a vacancy rate of just 12.2%, while the 40.8 msf of inventory with published asking rates below $28.00-psf had a vacancy rate of 19.7%.
It is obvious demand for office space in Kansas City continues to exist, but it is equally clear that investment is required to create a supply that matches the demand. Kansas City has historically been a market with limited speculative office development, but the older Class B product that populates much of the market is increasingly viewed as obsolete by many tenants. There are legacy buildings in both Class A and Class B that have made significant capital investments, and the leasing activity and occupancy stats show those investments are being rewarded. Tenants have shown a willingness to pay the increased rates associated with higher quality space.
Outlook
A large engineering firm has been advancing plans for a major development project along the College Boulevard corridor that would include a new Class A+ headquarters building but no speculative office space was noted in the most recent plans.
Leases have been signed and vacant spaces are awaiting tenant move-ins scheduled for the fourth quarter, but some of those move-ins are local relocations that will create negative absorption and offset the statistical impact.
Occupiers have shown an increased focus on tenant improvement work and maximizing the impact of ownership investment in properties, a trend that is set to continue and will likely result in more emphasis on upgrading the space a tenant occupies and delivering value for increased rental rates.
