Finally, An Uptick in Office Rents

Office landlords got some welcome relief in the first quarter, when average rents nationally rose by 0.7% to hit $20.25 per sq. ft., up from $20.11 per sq. ft. at the end of 2004, according to data research firm Reis.

It was the first time in four years that effective rents have increased, and a nice change from the first quarter of 2004 when average rents fell by 0.7%.

“The aphorism that a rising tide lifts all boats may be rooted in nautical truth, but it does not translate easily into a philosophy of real estate investing,” says Lloyd Lynford, president and CEO of Reis.

In reality, scores of major office markets are still limping, and some won't make a full recovery for several years to come. What's misleading is that frontrunner markets such as New York City and Washington, D.C. effectively skew the average.

Here's why: Manhattan, with its 358.2 million sq. ft. of office market space, accounts for 10.3% of the 3.5 billion sq. ft. of national office market space. That's the single biggest chunk of office space in the nation. Reis tracked 1.3 million sq. ft. of positive leasing absorption in Manhattan during the first quarter of 2005.

Manhattan wasn't the only market on the positive side. Among the top 64 markets in the nation, 44 recorded positive absorption in the first quarter. Among the 22 weakest markets were Detroit, with -372,000 sq. ft. of leasing absorption and Kansas City, with -377,000 sq. ft.

The upshot for tenants is that in strong markets they are renewing their leases early, while the getting is good. Elsewhere, tenants are simply riding out their lease time until the price of renting bottoms out. Some markets, including the likes of Washington, D.C. and southern California have already priced the recovery into their rents (see chart below) while others are finding it harder to hike rents.

“Chicago is one of the weakest office markets in the nation, but we're still getting more and more inquiries for space there,” says Bob Bach, national director of research at Grubb & Ellis.

Another laggard in terms of rental growth is Seattle. Bach says that Seattle turned the corner on vacancy rates between the end of 2002 and the beginning of 2004. Indeed, Grubb & Ellis data shows metro Seattle vacancy rates falling from 18.4% to 14.4% over that same two-year period. But the Pacific Northwest's largest metropolitan area is still struggling to bring office market rents up.

Job growth, particularly in the professional services sector, will help Seattle landlords win back some much needed control. Over the past 22 months, roughly 3.1 million jobs were created across the country. A full 609,000 of those jobs were created in the professional and business services sector, which typically requires office space.

While the month-to-month gains may be uneven, an average of 178,000 new jobs were created per month between February 2004 and 2005. The good news extended into March, when the unemployment rate fell 20 basis points to 5.2% — its lowest level since September 2001.

More good news: The amount of sublease space in the national office market also is falling. It hasn't dipped below the nine-digit mark in terms of square feet but it's moving down, says Bach.

Grubb & Ellis data shows 146 million sq. ft. of sublease space on the national office market at the end of the first quarter in 2002. Two years later, that number was hovering at 104.9 million sq. ft. That works out to roughly 22 million sq. ft. of sublease absorption per year. At that rate, sublease inventory will dip below early 2000's record low level of 37.1 million sq. ft. by about 2008.

“Two years ago we were very concerned about the huge sublease glut, but it's thinned out considerably since then,” says Bach. He believes that the balance of the sublease inventory will be leased due to a market twist: As direct rents get more expensive, sublease rates will start looking better.

“There's no question,” says Bach. “An increase in rental rates should help thin sublease out even more.”

Top 5 2004-Q4 2002-Q4 % Change
Orange County 11.5% 16.4% -4.9%
Washington, D.C. 10.9% 13.1% -2.2%
Riverside-San Bernardino 9.5% 13.1% -3.6%
Palm Beach County 11.1% 17.3% -6.2%
Las Vegas 12.2% 15.4% -3.2%
Bottom 5
Seattle 15.5% 18.2% -2.7%
Houston 19.0% 17.3% 1.7%
Chicago 19.9% 18.4% 1.5%
Austin 18.5% 23.2% -4.7%
San Jose/Silicon Valley 17.2% 20.0% -2.8%
Source: Grubb & Ellis
Top 5 2004-Q4 2002-Q4 % Change
Orange County $28.16 $24.48 15.0%
Washington, D.C. $33.63 $30.54 10.1%
Riverside-San Bernardino $22.13 $20.37 8.6%
Palm Beach County $28.79 $27.20 5.8%
Las Vegas $27.88 $26.43 5.5%
Bottom 5
Seattle $25.37 $27.07 -6.3%
Houston $20.85 $22.26 -6.3%
Chicago $27.95 $30.52 -8.4%
Austin $21.36 $23.27 -8.2%
San Jose/Silicon Valley $29.39 $36.60 -19.7%
Source: Grubb & Ellis
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