October 2003
By ROBERT PEGG
U.S. office markets continue to be under pressure by the nation's weak economy. Over the past two years, most office markets in the nation have experienced increasing vacancy rates, sharply lower rents and negative net office space absorption. Negative net absorption is a condition where the amount of space given up by existing tenants exceeds the amount of space occupied by new tenants. U.S. office markets had never experienced negative net absorption in the 20 or so years for which real estate data is available. The 9/11 terrorist attacks stimulated many companies to attempt to dump underutilized space, which pushed the negative absorption rates to record levels in the months following to the attacks.
However, since commercial real estate markets are affected by a combination of local as well as macroeconomic trends, there is a substantial variation in office space demand across the nation's office markets. The best proxy for office space absorption is growth in an area's office occupying employment base. Based on this measure, the weakest areas in the nation include New York City, Boston, and Northern California, where job growth has been stagnant.
Rapid increases in sublease space also are contributing to weaker office markets. In some cities, space available for sublease is estimated to account for as much as 50 percent of all vacant office space. This situation creates significant problems for landlords. Needing to reduce expenses and losses, many landlords solicit new tenants to assume existing leases by offering enticements such as rental rates below market levels. Depending on the extent of the rental rate cuts and the magnitude of the practice, subleasing has been a major contributor to the downward pressure on market rental rates over the last two years.
According to a
study by the Federal Deposit Insurance Corporation (FDIC), rental rates are
falling in a predictable pattern as office vacancy rates have risen. During the
early 1990s recession, office rental rates declined for only two years, in 1992
and 1993 at
-3.9 percent and -8.1 percent respectively. In this cycle, rents began falling
in 2002, when they declined 6.7 percent over 2001. From year-end 2002, rents,
nationwide, are down by another 1.5 percent. In San Francisco, for example,
office rents increased 44 percent in 2000. Since then, the rental market there
has dropped 50 percent in 2001, followed by another drop of 27 percent in 2002.
Office vacancy rate increases have occurred in every U.S. market and a number of cities with very low office vacancy rates at year-end 2000 have now experienced sudden and sharp increases in office vacancy rates. In the last economic cycle, the nation's average office vacancy rate peaked at 19.2 percent of space available. Through the 1990s, vacancies gradually declined. The national vacancy rate remained in double digits through 1997 before hitting a bottom of 8.6 percent in 2000. Since then it has approximately doubled.
Other commercial real estate markets also are feeling the effects of the nation's economic weakness. Warehouse demand still is poor, according to Economy.com, an economic consulting service in Philadelphia. However, unlike the office market, no further deterioration is expected. While industrial vacancy rates may have peaked at about 12 percent, demand for goods and distribution is forecast to remain sluggish. The biggest problem with respect to industrial property demand is the poor health of the nation's manufacturing industries, which play a disproportionate role in the demand for industrial space. Consequently, the flattening of manufacturing activity through the Midwest and the tech centers of the Northeast has contributed to a drop in demand for industrial space.
The good news is in the retail sector. Here rental rates have been flat for the past several quarters, but consumers have continued to spend. According to recent data, retail sales have slowed but continue to be positive on a year-to-year basis, despite a poor job market and rising bankruptcy filings. The retail markets with the best potential are those that boast a healthy share of high-income households.
In summary, the bottom line for commercial real estate is that conditions, as poor in some sectors and cities as they may be, have seen worse in past downturns. If the economic recovery ever picks up some steam, the poor conditions will soon be past us.
About the author: Mr. Pegg is president of Kirkbride Asset Management, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.