Rental Rates Are Rising... Aren't They?

RENTAL RATES ARE RISING...

AREN’T THEY? Q3 2015 Special Report

AQUILA Q3 2015 SPECIAL REPORT

This quarter, in light of the 14 quarters of rent growth in Austin over the last 16 quarters,

the AQUILA Market Research Department set out to achieve a more holistic understanding of this growth, taking into account all factors, especially the ongoing rise in construction pricing.

According to Turner Construction’s Building Cost Index, which measures costs in the non-residential building construction market nationwide, there has been an 11.8% increase in construction costs since 1Q 2013. This index includes labor rates and productivity, material prices, and the competitive condition of the marketplace. The Houston market (data for Austin is not tracked) has seen a 14.3% increase in standard office space buildout between 2013 and 2015, according to Kirksey Architecture’s Construction Cost Update. By contrast, full service rental rate growth in Austin, TX over the same period was a comparable 13.9%. But, for a truly local analysis, AQUILA compared face rates and effective rates over the last 24 months to better understand rate dynamics in each of the city’s major submarkets.

METHODOLOGY Our analysis examined lease comps for our competitive set of buildings (see Appendix) in the major Austin submarkets (CBD, NW, and SW) that commenced January 1, 2013 through the end of 2015. To make sure that leases similar in nature were being compared, only new leases were included in this study. Excluding renewals eliminated the variability associated with the general practice of owners signing leases with conventionally lower tenant improvement allowances (TIs) than those offered to new tenants for a new space. A similar study we conducted, which included renewals and expansions, netted similar results on a less dramatic scale. Considering the rising costs of construction, which generally affects new leases more, we felt it prudent to only concentrate on the new leases in this report to show a clearer picture. This filtering netted 333 leases used in the study (CBD: 100, NW: 125, and SW: 108).

Two calculations were made for each lease and compared to each other:

• Average Full Service (FS) Rate. This rate is the average total annual payment made by the tenant over the course of the lease term, measured in dollars per square foot. Rent abatement and operating expenses are included.

• Average As-Is Full Service (FS) Rate. This rate prorates the TIs over the term of the lease and subtracts them from the Average FS Rate.

Keeping the operating expenses in both calculations maintains a better “apples-to-apples” comparison while illustrating what tenants are paying out of pocket. The two calculations for each lease were plotted on a graph at the corresponding lease’s commencement date and a regression line was inserted to show the behavior of the rates over time.

AQUILA Q3 2015 SPECIAL REPORT

RESULTS

Graph 1: Citywide Avg. Full-Service vs.

Avg. As-Is Full-Service Rental Rates

In Graph 1, the trendlines show the

$55

disparity between the rates becoming

$50

smaller around the beginning of 2014, but more than doubling less than two

$45

years later. When broken down into different degrees, with the exception of the NW submarket where the variance was roughly the same. The gap illustrates

$40 Rental Rate ($/sf)

submarkets, the same held true to

$5.74

$35

$2.99

$2.57

$30

the difference in the Average FS Rate and

$25

the Average As-Is FS Rate, which can be translated into the amount an owner is

$20

providing in TIs. $15 Jan-13

There are a number of explanations that

Apr-13

Jul-13

Oct-13

Average FS Rate

Jan-14

Apr-14

Average As-Is FS Rate

Jul-14

Oct-14

Average FS Rate Trendline

Jan-15

Apr-15

Jul-15

Oct-15

Average As-Is FS Rate Trendline

can account for the cause of these trends:

1.

Construction costs are increasing

Graph 2: CBD Avg. Full-Service vs.

Avg. As-Is Full-Service Rental Rates

across the board. The more it costs tenants to build out their space, the less

$55

likely many tenants will be able to afford to move into nicer buildings. Owners

$50

don’t want to lose the long term income

$6.92

by foregoing upfront costs in the term of

2.

New product in individual submarkets

come in different flavors. As noted before, the CBD and SW submarkets followed the

Rental Rate ($/sf)

additional TIs.

$45

$40

$3.56 $3.48

$35

trend of the majority of the overall Austin market, whereas the NW bucked the

$30

trend. The recent new deliveries in Austin adhered to the traditional principles of the submarkets.

$25 Jan-13

Apr-13

Average FS Rate

Jul-13

Oct-13

Jan-14

Average As-Is FS Rate

Apr-14

Jul-14

Oct-14

Average FS Rate Trendline

Jan-15

Apr-15

Jul-15

Oct-15

Average As-Is FS Rate Trendline

AQUILA Q3 2015 SPECIAL REPORT

Downtown and SW buildings are superior products, whereas the NW has more traditional space. The need for higherend improvements drives up the tenant buildout costs. To entice users to come to these new buildings, owners have been increasing their concessions. In the NW, owners can still increase their rental rates due to the hot market, but do not have to worry about giving as much money for improvements for standard space. Additionally, many tenants that have been priced out of the CBD and SW submarkets tend to do deals in the NW and will stick to a more budgetfriendly rent while also forgoing pricey improvements to their space.

3. Existing product is not immune to submarket trends. Coinciding with the development tendencies, the CBD and SW submarkets have seen more inflation with purchases of existing product than the NW submarket. Because of this higher $/sf for the purchase, landlords need to charge higher rental rates to support recent acquisition prices. Again, to lure tenants to these expensive spaces, higher tenant improvement allowances are a tool owners have been effectively using. For the most part, NW submarket properties have been consistently filling

Graph 3: Northwest Avg. Full-Service vs.

Avg. As-Is Full-Service Rental Rates

up so the market is healthy, but there are $45

significantly more “large availabilities� out there compared to the other submarkets.

This risk to investors coupled with a

$40

large number of available product in the submarket, dictates a lower $/sf on translates to owners being able to ask for lower rental rates than the CBD and

Rental Rate ($/sf)

purchases. The lower purchase price

$35

SW in a submarket where cost-conscious

$2.95

$30

$3.03 $2.63 $25

tenants are already attracted. $20

WHAT DOES THIS MEAN FOR YOU?

$15 Jan-13

Tenants: You should expect to keep

Apr-13

Jul-13

Average FS Rate

Oct-13

Jan-14

Apr-14

Average As-Is FS Rate

Jul-14

Oct-14

Average FS Rate Trendline

Jan-15

Apr-15

Jul-15

Oct-15

Average As-Is FS Rate Trendline

paying more in rent than you would have a year ago, but you can expect a nominally

Graph 4: Southwest Avg. Full-Service vs.

Avg. As-Is Full-Service Rental Rates

larger tenant improvement allowance.

Even with increased tenant improvement

$45

funds, you will likely see the achievable scope of work for your tenant finish is not

$40

necessarily going to be any greater than it would have been a year ago. are

underlying

market forces that are pushing for more concessions in your leases. Is it more important to save a couple dollars per

Rental Rate ($/sf)

Landlords: There

$35

$30

$6.33 $1.59

$2.92

$25

square foot in upfront allowances or to charge more in rent over the life of

$20

the lease? Though revenue continues to increase, landlords are having to pay more out of pocket to tenants.

$15 Jan-13

Apr-13

Average FS Rate

Jul-13

Oct-13

Jan-14

Average As-Is FS Rate

Apr-14

Jul-14

Oct-14

Average FS Rate Trendline

Jan-15

Apr-15

Jul-15

Oct-15

Average As-Is FS Rate Trendline

View more special reports at:

aquilacommercial.com/reports

The information contained herein has been obtained from sources believed reliable. AQUILA Commercial, LLC makes no guaranties or warranties as to the accuracy thereof. The presentation of the property is submitted subject to the possibility of errors, omissions, change of price, rental or other conditions, prior sale, lease or financing, or withdrawal without notice. Included projections, opinions, assumptions or estimates, are for example only, and may not represent current or future performance of the property. Information is for guidance only and does not constitute all or any part of a contract.