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Producer Price Indices for Nonresidential Construction Increased In January 2023

All eyes are still on inflation as markets anticipate the second 2023 meeting of the Federal Reserve where they will decide on the 8th rate hike of this tightening cycle. In January, the Consumer Price Index (CPI) for All Urban Consumers increased 0.5 percent month over month and was up 6.4% over the last 12 months, rising more than expected. In addition, January’s Producer Price Index also increased more than anticipated, showing slight increases month over month for  non-residential construction for both goods and services. While both indices (net inputs to non-residential construction for both goods and services) remain below their June and May 2022 highs, respectively,  they are still up significantly from January 2019. The PPI for goods is up 39.6% from the beginning of 2019 followed by a 32.3% increase for services. January’s rise is concerning because it is considered a leading indicator of consumer prices. The PPI measures the selling prices received by domestic producers and its rise could indicate more increases to come for the CPI overall as producers pass these increases on to consumers.

Strained supply chains caused growth in the PPI for goods to outpace growth in services after the start of the pandemic. Although supply chain issues and prices have since eased somewhat, the PPI for nonresidential construction is still well above pre-pandemic levels and this means prices are still up for many of the raw materials as well as services that are needed for construction including interior fit outs of office space. 

In today’s blog, CompStak evaluates how average tenant improvement allowances have trended across five major markets, including Washington D.C., Los Angeles, New York City, Bay Area and Boston and how they compare. Tenants completing office deals over the last two years have faced these rising costs of construction and materials and were able to negotiate for substantially higher tenant improvement allowances, especially in a strong tenants’ market and with higher quality space increasingly favored.

Rise in Work Values since 2019 Outpaced PPI Growth in Boston and Bay Area

According to CompStak’s data, rising work values across major office markets since January 2019 have tracked closely with increases in the PPI. Two markets saw growth in work values that exceeded PPI growth for Goods, including the Bay Area where the average work value increased 55.7% and Boston, where it expanded 40.0% from the the beginning of 2019 to the end of 2022. Los Angeles, New York and Washington also experienced substantial growth over this period, with growth rates of 29.1%, 28.5% and 27.3% respectively. However, this growth rate fell slightly short of the growth for goods in the nonresidential construction PPI in the same time period (+35.2%).

Average Work Values Grew More than 9 Times as Fast as Average Starting Rents in Bay Area From Beginning of 2019

Overall, growth in work values well outpaced growth in base rents* for closed office transactions in each of these markets. Three markets experienced growth in work values between 2.6 and 2.8 times as fast as average starting rents growth: Los Angeles County/Orange County, New York City, and Washington, D.C.. This is due to their similar percentage increases in average starting rents (between 10% and 11%) and average work values (between 27% and 30%) between Q1 2019 and Q4 2022. Boston saw average work values grow roughly twice as fast as starting rents (+40.0% versus +19.2%), even after excluding costly life science tenant fitouts, putting it more in line with other markets by this metric.

But comparatively, the Bay Area is an outlier when analyzed over the same period. Among tracked markets, it experienced the highest growth in average work values (+55.7%) coupled with the lowest rent growth (+5.9%), meaning average work values grew more than nine times as fast as average starting rents.

The Bay Area has the second lowest office occupancy rate among the ten markets tracked by Kastle in this week’s data (42.1% for San Jose metro). Weak rent growth and strong work value growth indicates that it remains a strong tenant’s market, especially as technology firms have pulled back and continue to reassess their office needs amid layoffs and cost cutting measures. This is a stark reversal as technology firms were the bedrock of pre-pandemic leasing demand. A dramatic increase in tenant improvement allowances suggests that landlords may be offering higher work values to compete and close deals with a smaller active pool of tenants.

*Base rent means the starting rent for a closed transaction and differs from an effective rent which accounts for free rent periods and work packages received (except for the Bay Area, where work values are not part of the effective rent calculated).

Work Value as a Percentage of Total Deal Value up Across Markets from 2019

With rising work values and lagging rent growth, the ratio of work value received to total rent paid by tenants has increased substantially over the last several years. Work values as a percentage of total deal value have surpassed 2019 levels in all five of markets analyzed. This ratio expanded 1.2 percentage points in New York City, 1.3 points in Washington, 1.5 points in the Bay Area, 2.1 points in Boston, and by more than 5.1 points in Los Angeles and- Orange County markets.

The ratio has increased every year in both Los Angeles and New York. Los Angeles had the highest ratio out of the five markets in 2022, at 19.7%. Boston was the only market in which average work values as a percentage of total deal value declined slightly from 2021 to 2022 (-0.2 percentage points).

Across the five markets, New York City boasted the lowest average work values as a percentage of total deal value every year except for 2020, in which the Bay Area saw a steep decline from 2019. While New York has the highest average work value among these markets,  it has had the lowest ratio of work value to total deal value over the last two years.

Will work values continue to climb or stabilize? 

The rise in work values over the last several years was influenced by a perfect storm which included a competitive tenants’ market, rising construction and materials costs, and a demand for high quality, amenity-rich workspace among those tenants completing transactions. A decline or stabilization in work tenant improvement allowances could suggest an abatement in any or all of the above three factors over the next year. However, office landlords are now facing maturing office loans in a period of increasing interest rates (and office defaults are already on the rise) at the same time as there is still lackluster demand and increasing lease rollover. With property owners’ capital costs on the rise, there may be increasing resistance to providing higher work allowances as their bottom line is now being challenged from multiple headwinds. 

Curious about how work values are trending in your market? Try CompStak.

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