Demand for Office Space by Firms: Drivers and Determinants
by Petros S. Sivitanides, Ph.D.
The demand for office space is a derived demand because firms rent space as an input to the production of services or goods they provide to businesses and households in the local, regional, or national economy. According to office
building surveys, the major tenants of office space are firms providing finance, insurance, real estate (FIRE), and other services, including primarily professional, business, and government services (Wheaton 1987). Within the service sector, DiPasquale and Wheaton (1996) consider the following types of firms as office space users: advertising, computer and data processing, credit reporting, mailing and reproduction, legal and social services, membership organizations, and engineering and management services. Thus, if market demand for such services increases, demand for office space will also increase (to the extent that the additional demand for services cannot be satisfied by existing firms without using any additional space).
The aggregate demand for office space at the broader market level refers to the total amount of square feet of office space demanded by all firms interested in operating within that market. This is actually the sum of the individual office space demands of each of these firms. The demand of an individual firm for office space depends on the size of the firm, that is, the number of its employees and the amount of office space used per employee.
Within this context, the total amount of office space demanded at the broader market level is determined by the number of firms utilizing office space (I refer to these firms as office firms), the size of each firm in terms of number of employees, and the amount of office space per employee demanded by each firm. Actually, aggregate demand for office space in a market is the product of these three factors (number of firms x average number of employees per firm x square feet per employee). Also notice that the product of the number of office firms times the average number of employees per firm gives the total office employment in the market under consideration.
Obviously, the greater the number of firms, the greater the average number of employees per firm, and the greater the amount of square feet per employee required by each firm, the greater the total amount of office space demanded within a market. Within this context, increases in aggregate market demand for office space can be triggered by (see figure below):
Forces that Trigger Increases in Aggregate Demand for Office Space
1) Increases in the number of office firms operating in the market 2) Increases in the average number of workers employed by each office firm, and 3) Increases in the amount of office space per employee demanded by each firm. Notice that demand for office space will increase if one or more of these factors increase, as long as no counterbalancing decreases in the other factors take place. Also, notice that the stronger the increases in these factors, the stronger the increases in market demand for office space (all else being equal).
Increases in the Number of Office firms Operating in the Market
Increases in the number of office firms operating in the market can be triggered by economic, population, and/or income growth (see Figure 26). Such growth will trigger increases in demand for services, which in turn will stimulate the birth of new firms and/or expansion of existing ones, which will boost local demand for office space. It should be noted that the service sector, which includes most of the office-space-using firms, has been growing faster than any other sector for decades because of the ongoing transition of the economy from a manufacturing one to a service one. Economic growth of metropolitan markets depends largely on how the national economy is doing, but there are significant variations in economic growth rates across markets due to differences in sectoral structure, production cost differentials, and local market dynamics. Empirical evidence presented by Erickson and Wasylenko (1980), Carlton (1979), and Bartik (1984) verifies the use of the cost minimization approach in business location selection and, therefore, the influence of production cost differentials in driving job growth. These studies suggest that business location is affected by agglomeration (concentration of firms), unionization rates, wages, and corporate taxes. Predicting though employment growth across metropolitan markets is more complex than simply recognizing the effects of these factors. That is why econometric forecasts of metropolitan employment and income growth can be very valuable to national investors pursuing high returns in office investments.
Increases in the Average Number of Employees per firm
The second factor that determines aggregate demand for office space is the average size of the firm, in terms of number of employees. This depends on the average productivity level in each industry. The term productivity refers to the number of workers required to produce a given level of output (or number of workers needed per unit of output). If firms in service industries find themselves in a position where they will need to use more workers to produce the same level of output, the average number of employees per firm will increase and demand for office space will increase, too (all else being equal). Such a development though would represent a decline in productivity though. The outlook for productivity declines and increases in the average number of workers employed by office firms is highly questionable, given a long-term trend of rising productivity. Normally, automation and technological advancements make each employee more efficient and more productive, increasing the output produced per worker and reducing the total number of employees needed to produce a given amount of output. Economists and real estate analysts have expressed fears that rapidly rising productivity (output per worker), due to advancements in technology and information processing, may limit office employment growth and demand for office space in the future. An alternate view is that most possibilities for dramatic improvements in office worker productivity have been exhausted. Nevertheless, productivity losses, which are needed to push the average number of employees per firm up, are not very likely in the foreseeable future.
Increases in the Space per Employee Demanded by Office firms
Non-price factors that influence office space requirements per employee include the type of services provided by the firm, the growth prospects of the firm, and the profitability of the firm. Within this context, increases in the square-feet-per-employee requirements of office firms can be triggered by: a) Employment growth in service activities that require a greater amount of space per employeeb) Expectations for faster growth in the future c) Increases in office firm profitability Increases in service activities that require a greater amount of space per employee- Space requirements per office worker vary by industry. It is often argued that space requirements are greater in the case of firms that are active in the prestigious finance, insurance, and real estate sectors. Carn et al. (1988) suggest that space-per-worker requirements vary by occupation, with managers and professionals occupying more square feet than clerks and secretaries. Therefore, the average square feet per employee should vary across markets, depending on the composition of their service industries and their occupational structures. Thus, employment growth in service sectors that use managerial and professional labor in greater proportions should contribute to an increase in the average square feet required per employee, and, hence, to an increased in market demand for office space. Daniels (1975) suggests that the amount of space occupied by each office worker has increased steadily throughout the years, for a number of reasons. These include the growth of administrative and professional occupations, which tend to utilize more space per worker, the increasing scale of office machines and equipment, and the increase of ancillary space in office buildings, such as staff lounges and reception rooms. Daniels argued that future changes in the demand for office space per worker would depend on the degree to which elite office activities that demand a greater amount of space per employee continue to increase their share in the nation’s total economic activity.
Expectations for faster growth in the future- Expectations regarding future growth prospects affect a firm’s demand for office space, because commercial leases are usually multi-year, making the leasing of space a long-term commitment on the part of the firm. For example, if a firm evaluates that it will be growing faster in the immediate and mid-term future, it will demand a greater amount of space per employee in order to accommodate future expansion needs. If, however, the company expects deceleration of its growth rate, it will demand less space per employee. Firms tend to be more optimistic when the economy is growing, as opposed to when it is declining. Therefore, it is more likely that firms will expect faster growth in the future, when economic growth is accelerating. This suggests that during periods of accelerating employment growth, office space demand gets a double boost. This double boost is likely to come from increases in office employment and increases in required office space per employee. Therefore, short-term investments in office buildings, in markets where economic growth is about to accelerate, is likely to provide big profits, if the market vacancy rate is low and completions of new office space are expected to be low. Increases in office firm profitability-The amount of space per employee demanded by a firm should also be influenced by its profitability. For example, increases in company profitability should reduce pressure to restrict office space use, as less profitable firms might need to do. Sivitanides (1990), in an unpublished study of 19 major office markets in the US, found that areas in which office employment represented a smaller share of total employment, the amount of occupied office space per employee was greater. This can be explained based on the profitability argument, if we assume that each of the office-space-using firms in these areas enjoys a greater market share (since the total pie is divided among a smaller number of firms) and is, therefore, more profitable. Based on the above discussion, we can trace the characteristics of markets and circumstances likely to create the dynamics that will generate high returns, in the short-term, for investments in office buildings: - The major office space using sectors-FIRE, business, professional, and government services, are predicted to grow rapidly in the near future - The local economy is predicted to grow at accelerating rates - The local market vacancy rate for office space is relatively and sufficiently low
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