Darkness Before Dawn

The sublease overhang that's been plaguing the national office market for nearly two years is finally showing signs of shrinking. Roughly 30 million sq. ft. of vacant sublease space was absorbed in 2003, leaving a still hefty 111 million sq. ft. on the market at the end of December, reports CoStar Group. The vacancy rate, including direct and sublease space, was an unhealthy 16.9% at the end of 2003.

Worse yet, that well-documented glut doesn't even include so-called shadow space — leased office space that is not occupied. Market researchers estimate that shadow space can add as much as 3% to the overall vacancy, which kicks the real vacancy rate up to nearly 20%. That's significant because the additional vacancy will slow the absorption of office space.

“Normally, shadow space in a healthy market might make up 5% to 7% of all leased office space. We now believe that it's as much as 10% of the leased space nationwide,” says Bill Goade, chairman of tenant rep firm CRESA Partners.

By that measure, a large corporate tenant leasing 1 million sq. ft. of office space nationwide isn't using roughly 100,000 sq. ft. of that total. Indeed, a report released in January by UBS Investment Research estimates that 39% of all U.S. corporations have shadow space in excess of 10% throughout their portfolios of leased property.

Historically, says Goade, the creation of roughly 100,000 new jobs per month has preceded office leasing demand by about six months. Factor in that 10% surplus of shadow space, however, and Goade predicts that the lag will be extended by another six months.

But without any real job growth, it's a moot point. According to the Bureau of Labor Statistics (BLS), only 1,000 new jobs were created in December, while some 309,000 people stopped looking for work.

Against that backdrop, what action are tenants likely to take in the short term? Goade believes that if a tenant leasing 100,000 sq. ft. is using only 75,000 sq. ft. of its space, the tenant is likely to seek a smaller space upon renewal. “The subleases eventually become direct space when the lease rolls over, but the shadow space can easily lead to a smaller lease renewal,” says Goade.

The only way to reverse the trend is through positive absorption, but the acres of shadow space make such a task tricky to pull off. The good news is that with the flood of sublease space drying up, it will eventually lead to stabilized or higher rents, according to CRESA Partners. But at the moment, landlords can only dream of better days ahead. In some markets, rents for sublease space are 40% lower than direct space.

“Real estate is on the upswing,” says Robert Bach, director of research for Grubb & Ellis. “But it will take some time to reverse the effects of the 2001 recession and the job-loss recovery of 2002 and 2003. And it will take several quarters — or even years — before asking rents make a complete turnaround.”

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