The overall performance of Tucson’s professional office and medical market remained solid through Q1 2018, with a slight shift in overall vacancy to 8.9%. Market fundamentals were significantly improved year-over-year, as demonstrated by the vacancy rate improving from 10.6% in Q1 2017.
With healthier fundamentals, landlords have begun testing rental increases; overall asking rates ticked up from $18.93 per square foot (sf) in Q4 2017 to the current $19.11 per sf. Regardless, landlords still competed on rate and concessions to land larger tenants with stronger credit. Better quality, well-located and managed properties experienced the greatest success in raising rates and filling space.
Sellers of user properties also held firm on desired pricing. Investment sales were limited, with buyers still requiring large discounts for any vacancy/risk the property presents. Much of the interest in investment properties was from out-of-market buyers, as cap rate compression in larger markets created opportunities in Tucson.
Lower demand has prevented speculative development; however the market saw more build-to-suit activity, primarily from the medical sector. Office condominium projects, old and new, have experienced more interest and inquiry than the rest of the market.
Economy
Arizona posted healthy job growth when as predicted, the Bureau of Labor Statistics revised data indicating that Arizona employment actually grew 2.4% during 2017 versus a previously reported 1.7%. Tucson job growth for the year was also revised, up to 1.5% and early in Q1 2018, employment has held steady.
The national trend of tight labor markets, impacting pricing and space demands, set the tone for Tucson to follow suit. In the short term, this may be good news as rental rates rise, but in the long-term threatens growth if labor markets stay tight, deliveries stagnate and the federal funds rate continues to rise.
In February, the average sales price of Tucson homes rose 3.3% to $249,095 while new single family housing permits were up 13.7% year-over-year. January retail sales in the Tucson MSA were up 6.9% over the prior January.
Outlook
Margins will tighten as the Fed hints at instituting a rising interest-rate environment, with two or three more rate hikes to come in 2018. Consequently, this interest rate increase will drive up cap rates. The current cap rates in the Tucson office market were already high; therefore we may benefit from a lag on increases until the wider than average gap compresses enough to push the cap rates higher.
We expect to see incremental increases in lease rates as vacancy continues to decrease. Tucson continues to achieve small wins, attracting new employers to the market. The additional primary and peripheral jobs will increase tenant demand for office space, eventually shifting the advantage to the landlord side.
Assuming job growth stays on its current trajectory, lease rates will increase enough to justify new construction and redevelopment of older obsolete inventory.
