That Empty Feeling

When will the office market see the end of the double-digit — and still rising — vacancy rates and declining rents? The answer is another question: When will companies start adding jobs instead of shedding them?

Nobody can say when that will be. But the key barometer is job-growth data. Since the recession began in March 2001, some 1.4 million jobs have been lost. The rate of loss has slowed — to about 50,000 jobs per month, says Dr. Rajeev Dhawan, an economist with Georgia State University.

But what's needed to create fresh office demand is a return to healthy job creation, which is about 225,000 jobs per month when the economy is humming, he says. “Once we get close to generating 200,000 jobs on a regular basis, then we can start to make a dent in the vacancy rate,” he says.

The economist forecasts that the employment picture will begin to improve late this summer with the addition of 70,000 to 100,000 jobs monthly, but that a full employment recovery won't take hold until early 2003. “All indications of a recovery are there,” says Dhawan, citing increased industrial production as one indicator. “It just takes awhile to solidify.”

Even as the unemployment rate stabilizes, however, the rate that matters to office owners — vacancies — remains stubbornly high. The national office vacancy rate, which includes both direct and sublease space in all classes, registered between 14.2% and 16.7% in the first quarter of 2002, based on estimates by CB Richard Ellis, Grubb & Ellis and Cushman & Wakefield.

A year ago the same three brokerages reported national vacancy rates between 9.1% and 10.7%, and all three predict that rates could rise another percentage point before they start to fall. In the last big realty crunch a decade ago, nationwide vacancy rates peaked at around 18%.

Beyond the national averages, there is wide variation among cities and submarkets. Some of the worst vacancies, according to CB Richard Ellis, are in Dallas/Fort Worth, with a vacancy rate of 24.8% in the first quarter, followed by suburban San Francisco at 23.9% and suburban Atlanta at 21.3%. Markets bucking the trend include Washington, D.C., and Midtown Manhattan, with healthier vacancy rates of 5.5% and 8.2%, respectively, according to CB Richard Ellis. Their strength is their unique positions as economic and political centers where many tenants feel they must be. “Those two markets have an infrastructure in place that's not easily replicated,” says Alice Connell, group managing director for the mortgage and real estate division of New York-based TIAA/CREF.

Suburbs Hit The Hardest

National suburban and CBD vacancy rates were 17.30% and 12.79%, respectively, in the first quarter, according to Northbrook, Ill.-based Grubb & Ellis. The suburban vacancy rate rose by 136 basis points over fourth-quarter 2001 compared with a jump of 85 basis points for the CBDs. Why the big bump in suburban vacancy rates? It's largely because 84% of newly constructed space is in suburban markets, Grubb & Ellis reports.

Thirty-eight million sq. ft. of office space will be completed nationally this year: 10 million sq. ft. in the CBDs and 28 million sq. ft. in the suburbs. That's nearly a 60% drop over the 87 million sq. ft. completed in 2001, according to New York-based Cushman & Wakefield.

Citing the absence of a 1980s-style frenzy of speculative building that led to the collapse of the office market in the early 1990s, at least one market analyst expressed surprise by the depth of the current downturn. “I didn't think the vacancy rate would go so high as it has and that the market would stay in the tank for so long,” says Bob Bach, national director of market analysis for Grubb & Ellis. “It was a combination of the tech bubble and companies behaving differently this time around — laying off people quickly and throwing sublease space on the market. That was really unprecedented.”

John Cannon, a senior vice president with Horsham, Pa.-based GMAC Commercial Mortgage Corp., isn't convinced a rapid recovery is imminent. “I still think that companies are trying to be lean and mean, and squeeze as much profit out of the number of bodies they have. I don't see any demand for space anywhere,” says Cannon. “I'm not sure there still aren't some more dot-coms that are going to fail and give back more space.”

The Investment Perspective

Although corporate downsizing has resulted in 122 million sq. ft. of available sublease space — nearly four times what was available two years ago — industry experts say that the price per square foot on investment sales has generally held steady. That's due to the abundance of capital among private and institutional investors at home and abroad who are bidding aggressively on stable, well-occupied U.S. office buildings with long-term leases.

(all totals in millions of square feet)
CBD Non CBD Total (CBD +Non CBD)
1Q2000 1Q2001 1Q2002 1Q2000 1Q2001 1Q2002 1Q2000 1Q2001 1Q2002
Leasing activity 31.1 10.8 13.1 50.4 26.0 27.0 81.5 36.9 40.2
Direct Availabilities 78.4 73.4 102.4 155.2 166.0 240.2 233.6 239.4 342.7
Sublease Availabilities 9.6 19.0 40.1 21.4 39.6 81.7 31.0 58.6 121.8
Construction Completions 0.42 2.8 2.0 15.5 15.5 13.6 15.9 18.3 15.6
Source: Cushman & Wakefield

“We see few trades in the U.S. these days at discounts to replacement cost, whereas those were the only trades being made 10 years ago,” notes James Hime, senior vice president, Capital Markets Group, for Houston-based Hines.

On the basis of price per square foot, some expensive trades are occurring, confirms David Bernhaut, executive director of Cushman & Wakefield's financial services group in East Rutherford, N.J. Some properties on the block are attracting up to 15 bidders. During the first four months of 2002, four buildings have traded for $195 per sq. ft. or greater in northern New Jersey. Only four buildings fetched that amount in all of 2001, says Bernhaut.

Bernhaut cites a purchase in February by Investcorp as an example of foreign capital seeking stability in the office sector. The global investment group, with offices in the Persian Gulf country of Bahrain as well as London and New York, acquired One Centennial Plaza, a 236,000 sq. ft. Class-A office building in Piscataway, N.J., for $26.3 million, or $111 per sq. ft. That's characterized as a healthy price for the Middlesex/I-287 corridor in which well-stabilized properties generally trade for $90 to $110 per sq. ft. Great-West Life Assurance occupies two-thirds of the space and has nine years remaining on its lease while American Standard Cos. has four years left on its lease.

Bob White, president of Real Capital Analytics, a New York-based research firm, says that it's a seller's market today more than at any time during the past 18 months because, despite high vacancies nationally, there is a dearth of office properties on the market relative to the demand for investment properties. Investors, he says, want to get into the game now while interest rates are low and before market rents begin to rebound. Those investors include high net-worth entrepreneurs, opportunity funds, REITs and institutional investors. “There's a lot of capital out there that wants to be in office, mostly CBD,” says White.

White cites as evidence the bidding war in May between Jamestown Advisors, a German investor, and Chicago-based Equity Office Properties (EOP) for 1290 Avenue of the Americas in New York. Jamestown initially agreed to pay $700 million for the 2 million sq. ft. office tower, but Equity Office countered with $725 million. Jamestown ended up paying Metropolis Realty, an offshoot of the Apollo Real Estate opportunity fund, $745.5 million for the building. “For two such major buyers to be duking it out like that is pretty incredible,” White says.

Real Capital Analytics, which tracks office investment sales $5 million and higher, reports that $7.3 billion in deals were closed nationally during the first four months of 2002 compared with $12 billion over the same period a year ago, a 39% drop. At the same time, a record number of deals amounting to $6.7 billion were pending (under contract) through April 2002. How does one explain that discrepancy?

“January and February were especially slow, but activity started to pick up measurably in March,” says White. “The resurgence in activity most likely results from Federal Reserve Board Chairman Alan Greenspan's remarks in late February that the economy is showing signs of improvement.” Of the $6.6 billion in CBD deals either closed or under contract through April of this year, $3 billion of those assets are in Manhattan.

Investment opportunities abound today in CBDs, most notably the business districts of 24-hour cities, according to Connell, who points out that TIAA/CREF is looking for an annual return of 8.5% to 9% on trophy properties.

Connell also looks favorably on office submarkets in close proximity to 24-hour cities. She likes the Jersey City waterfront, across from Manhattan and some of the suburbs near Washington, D.C. — Bethesda, Md., and Arlington, Va. These markets share the same dynamics as the CBDs, including strong economic drivers and diverse talent pools, she says.

Although the national office market is fundamentally weak at the moment, commercial real estate remains more attractive to investors than the stock market, says Jacques Gordon, international director of research and strategy at Chicago-based LaSalle Investment Management. Corporate earnings growth is expected to be a paltry 4% to 5% this year, half of what commercial real estate is expected to yield, says Gordon.

Market 1Q2002 4Q2001 4Q2000
Boston $52.04 $54.42 $57.15
Chicago $36.41 $36.02 $35.63
Downtown N.Y. $43.75 $48.77 $52.37
San Francisco $35.16 $40.08 $80.16
Washington, D.C. $44.80 $44.60 $40.90
Source: Cushman & Wakefield

Some Historical Perspective

For owners and operators, however, the key number remains the vacancy rate, which is what will put a floor under falling rents. Put into context, the current slump is far less severe than the implosion of the office market in the late 1980s and early 1990s, when the national vacancy rate peaked at 18.01%, according to Grubb & Ellis. During that era, hundreds of savings & loans failed because they made risky commercial real estate loans. Many of the loans were on speculative developments that attracted few, if any, tenants and produced little or no cash flow. To clean up the mess, the federal government in 1989 established the Resolution Trust Corp., which sold off billions of dollars in portfolio assets of insolvent S&Ls.

“In my mind, there's no comparison to the last recession,” says Trish Kelly, group senior vice president for LaSalle Bank. In the 1980s, private developers were leveraged as much as 85%. Today, that leverage is typically 75% for private developers and between 50% and 65% for REITs, says Kelly.

Furthermore, significant pre-leasing has become standard operating procedure. In Manhattan, for example, there will be less than 1 million sq. ft. of construction completed this year, according to Cushman & Wakefield, and nearly 80% to 90% of that space is being constructed on a build-to-suit basis.

There also is less supply coming on line now than in the 1980s, when the nation's office supply expanded by about 200 million sq. ft. annually. In contrast, the office supply increased by about 70 million sq. ft. per year in the 1990s, according to David Congdon, vice president at Hines.

Hines is developing 191 North Wacker, a 37-story, 740,000 sq. ft. office tower in Chicago's West Loop. Hines officials say the project is 60% leased and is expected to be 75% leased by the time the building opens on Oct. 1 of this year. The law firm of Gardner, Carton and Douglas is the major tenant, leasing 235,000 sq. ft. Several other law firms are part of the tenant roster.

Ripple Effect of Sublease Space

In retrospect, Corporate America took on more space than it needed in the late 1990s, and this was particularly true of technology firms that had ambitious plans for future growth. When the tech bubble burst, the layoffs came en masse, and sublease space began to flood the market.

The excess sublease space embedded in the national vacancy rate is an important distinction from the previous downturn, says Connell of TIAA/CREF. “Much of that sublet space is under contract and generating rents. The tenants may not need the space. They're downsizing and cutting costs, but they're still on the hook for the rent.” In the recession of the early 1990s, direct vacant space that wasn't generating any income proved disastrous.

Nevertheless, available sublet space inevitably creates downward pressure on rents of new leases and renewals and is likely to have a negative effect on landlords' bottom lines in 2002, cautions Gordon of LaSalle Investment Management.

In some cases, tenants are paying landlords to opt out of their leases early, which creates a short-term windfall for owners. Equity Office Properties, the largest office REIT in the country, posted $58.2 million in early lease termination fees in the first quarter.

“But that also gives EOP a new problem, which is a bunch of direct space that has to be re-leased,” says Gordon. “At that point, the vacant space shifts from being the problem of the occupier to the problem of the landlord.”

According to Grubb & Ellis, Class-A and Class-B asking rents have fallen by about 14% and 13%, respectively, since peaking in the fourth quarter of 2000. Average effective rents, which take into account free rent and moving allowances, are off by more than 20% from their peak. Generally speaking, rents now are about what they were at the end of 1999, says Bach.

“What we may see happen in 2002 is a flight to quality,” explains Maria Sicola, senior managing director of research for Cushman & Wakefield. “That means if I'm a tenant and I have an opportunity to move into higher-class space, I may be able to do so because it's cheaper now than it's been in a few years.”

Because tenants have so many options, Dallas-based Trammell Crow's leasing strategy is to try to sign tenants to lease renewals years in advance, says Tony Long, a managing director at the company. “In a market like this, it is of the utmost importance to treat your tenant like a customer that has a choice to move from building to building, because he can.”


Once the downturn hit, ADC Telecommunications moved swiftly to unload excess space.

Probably no sector of the economy has shed more people, and vacated more office space, than the telecom industry. At the height of the technology boom, Eden Prairie, Minn.-based ADC Telecommunications employed 22,400 workers. In 2000, the company posted record revenues of $3.3 billion, up 30% over the previous year. Today, the telecommunication equipment provider's workforce stands at 10,000 after revenue shortfalls forced the company to adopt cost-cutting measures.

When signs of a recession surfaced in early 2001, the company's total real estate portfolio was estimated at 7 million sq. ft., with another 1.5 million sq. ft. in the pipeline. Today the portfolio stands at about 6 million sq. ft., equally split between office and manufacturing, and plans call for the portfolio to be reduced by another 2 million sq. ft.

ADC typically owns its large-scale manufacturing facilities, and it leases office, engineering and warehouse space.

“Our first move during the downturn was to immediately put a halt to all [planned] projects, and to cancel the leases that were in negotiations,” says Clint Baer, director of global real estate development for ADC. “Any growth-oriented project was terminated.”

The company quickly pared its real estate holdings by 1 million sq. ft. by selling off various companies and product lines, but that was only the beginning. “In certain markets, we vacated facilities completely and put those facilities up for sale or marketed sublease space,” says Baer.

ADC also consolidated operations wherever possible. About a year ago, the company entered into a synthetic lease on a new, 500,000 sq. ft. headquarters in Eden Prairie, but as a result of company-wide staff reductions, only 60% of the property was initially occupied.

Following an analysis of its facility needs in greater Minneapolis, ADC officials opted to close three facilities and either absorb those displaced workers into its world headquarters or place them in existing manufacturing facilities in nearby Shakopee, Minn. That consolidation of space will be complete by the end of this summer and will result in full occupancy of the headquarters building.

The company lately has taken advantage of a weak office market to exact better terms for space it is keeping. In Massachusetts, it renegotiated a lease for 80,000 sq. ft. that will save the company $1.2 million over five years. As part of the pact, the landlord has agreed to a substantial tenant improvement allowance.

“Once you see the downturn coming, it pays not to be shy. You need to get with your business leaders and managers to provide them with some options and a strategy to assist them in shedding large costs,” says Baer. “I think having real estate closely aligned with the business and operational units is an absolutely critical lesson we learned.”
Matt Valley

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