The office market

Offices will be cycling forward as the "hot" property type in 1995 and 1996. In some ways it is tempting to dwell upon the obvious story, the marked decline in vacancy rates. Central business districts and suburban nodes alike have sustained improved national average vacancies for two consecutive years now. While markets are still out of balance, with overall availabilities in the upper teens, the tightening trend now has widespread credibility. Investors are clearly behaving as though they expect good news to continue.

More remarkable is the underlying demand driving the vacancy decline. We have heard the naysayers tell us that a "jobless recovery" would confront us in the '90s. Trendwatchers have wrung their hands about fax machines, modems, telecommuting, "desk hoteling" and other manifestations of the virtual office, warning that the days of the traditional workplace were numbered. The doom and gloom crowd assured us that the job losses of the recession were permanent, betokening the irreversible shift from well-paying office careers to freelance consulting or hamburger flipping. Corporate downsizing and the tide of mergers only served to ratify the worst fears.

There are undoubtedly elements of truth in these prognostications. But, bottom line: American business has generated approximately one million office jobs within the past 24 months. A year ago our Forecast said, "the signs of office demand recovery are unmistakable for those willing to look at the numbers objectively." The market tracked our optimistic prediction in 1994. What of the coming years? Landauer regards the vigorous absorption pace as unsustainably high. The rate of job growth, well over 2% annually, is clearly above trend, and tenants are taking advantage of the trough in the rental cycle to satisfy short-term expansion needs. But even anticipating an easing of growth to an annual average of 1.5% in total employment, the nation's office markets can expect aggregate space absorption of 300 million square feet by 1999. This implies a thorough shift from a tenant's to a landlord's market by the end of the decade.

Investors are offering unmistakable evidence of renewed faith in the future of office markets. Hard evidence. As in hard cash. A review of Landauer's transactions database shows a sharp rise in the volume of office building sales. Numerous deals have been made in the institutional investment class of over $25 million.

Several categories of buyers are especially active. Owner/users are taking advantage of the availability of office buildings for immediate occupancy at a fraction of their replacement cost. REITs are hungry for product and domestic pension funds now want fresh office assets.

Overseas capital sources also contributed to the rise in transactions. The British, Dutch and Germans led the Europeans, followed by Pacific Rim participants from Hong Kong, Singapore and Indonesia. The Europeans concentrated their efforts in the East; Asians made major acquisitions in Los Angeles, San Francisco and New York. For the first time since the late-'80s, prospective buyers are in competitive bidding situations.

Opportunity funds still comb the markets for attractively priced offices. Lower-priced transactions outnumber deals over $100 psf by more than three to one.

Who are the sellers? Far and away the most conspicuous are the lenders-inforeclosure, banks and life insurers hip deep in the workout mire. The RTC and FDIC are largely out of the picture. While a few auctions remain, the RTC reported its asset liquidation program 92% complete at mid-1994. Texas has the greatest amount of remaining office properties under government control.

Landauer's Market Quality Ratings and our Momentum Index examine the demand/supply outlook for 60 major U.S. office markets, with an aggregate inventory of 3.2 billion square feet, ranging from New York, the nation's largest market, to the relatively small Greenville-Spartanburg, SC market.

With such a large and disparate set of cities under consideration, the range of market quality runs from solid improvement to extended difficulty. Careful selection remains essential, even as the horizon brightens.

In the Northeast, the entire quality spectrum can be found. Boston's office vacancy rate is already down near 10%. Landauer projects 45,000 office jobs will be generated in the Boston metro area by 1999 which will spur a new round of construction. Sales have stepped up in volume. Prices, now commonly up over $100 psf, indicate the investment community anticipates strengthening conditions.

Hartford, in contrast, suffers from an existing vacancy of 22%, and its expected 1.6% office employment growth rate translates to only 7,500 new jobs, not enough to turn around a market with approximately five million vacant square feet.

The encouraging rebound of values in New York, marked by sales of about $200 psf for Class A buildings and rumors of new construction, belies the fragility of its recovery. Manhattan still has a staggering vacancy of 58 million square feet, though, and values are substantially below their late-'80s peak. Landauer anticipates 68,000 office jobs will be created in the next five years, only a .9% annual growth rate. This slow pace accounts for New York's weak Momentum Index score of 40. We anticipate improvement over the forecast period but not enough to propel it into the upper echelons of market quality. A wide gap in vacancies and average rents exists between Midtown and Downtown. We expect this imbalance to correct, beginning in 1996.

Long Island, Westchester, southeastern Connecticut and northern New Jersey begin 1995 with higher vacancies. Relocations from Manhattan and local small business expansions will drive more rapid employment growth through 1999. Overall, the region's vitality and the health of its office market depend to a great extent upon New York's sustained growth. We expect a moderate regional recovery, more like the late-'70s than the boom of the '80s.

Philadelphia and Baltimore show similar 16% vacancies, but divergent employment prospects. Philadelphia's outlook resembles the slower-growth scenario for the New York metro area, with 19,300 office jobs anticipated for a 1.3% annual increase. Baltimore, especially in its suburbs, appears to benefit from being in Washington's sphere of influence. Office employment change is forecast at 19,800 jobs - virtually identical to Philadelphia's - but with much more impact in a market only 60% of Philadelphia's size.

In terms of absolute office job creation potential through 1999, Washington, D.C. ranks first. Landauer foresees 108,000 new workers in this metro area's service business base. This is a 2.1% annual growth rate, identical to the national average pace for office jobs in the 60 MSAs Landauer tracks. Investors continue to display an appetite for D.C. offices (at premium prices) implying substantial agreement with its Momentum Index score of 127.

The major cities of the Southeast are among the most attractive markets for the remainder of the decade, a result of their expanding and diversifying regional economy. Charlotte's Momentum Index score of 161 leads the region, riding the wave of its emergence as a major regional banking center. With such powerhouses as First Union, Nationsbank and Wachovia in its downtown, Charlotte CBD office space is scarce even now. We expect Charlotte will sustain an above-average growth rate, as the agglomerative benefits of this cluster of strong banks are realized. But it would be a mistake to extrapolate the extraordinary job performance of the past five years indefinitely into the future. Landauer projects an additional 12,000 office workers for the metro area, an annual increase of 2.5%, narrowing the gap between local growth and the national trendline.

Atlanta is a study in contrasts between the hale conditions of its suburbs and the sorry state of its downtown office market. Buckhead, the Perimeter and other northern submarkets have vacancies of 11%-12%, while the traditional center along Peachtree Street near the Five Points is languishing with a 23% vacancy rate. As a metro area, Atlanta has been ranking near the top of the nation in job growth and Landauer projects an additional 69,000 office jobs here by 1999, 2.4% annual growth on average. Some suspect that the run-up to the Olympics is inflating Atlanta's economic performance. But, Atlanta's job growth has been well distributed, its position as the prime business service center of the Southeast is consolidating and its link to international business is steadily expanding. Suburban offices were selling at $130-$180 psf in late-1994, at cap rates in the 9% range. Atlanta manifestly deserves its above-average 109 Momentum Index score.

This story is repeated, though less extremely, in Nashville where a 7% differential exists between dynamic suburban markets like Brentwood and the 18% availability downtown. Nashville earns a Momentum Index score of 141, with a projected annual demand increase of 2.6%, a total gain of 12,200 office jobs for the MSA within the next five years.

Rapid migration and revitalized economic ties with Latin America are spurring sharp advances for the major Florida cities. Tampa and Orlando remain top markets, and Miami has advanced to a position just below the national median. Tampa's projected office job generation, 3.1% per year, is the nation's fastest through 1999. Orlando is now the tightest market in the state. But its remarkable growth rate is beginning to resemble the nation's more closely, as its explosive growth evolves into a more mature phase. Miami's Coral Gables and airport submarkets are on solid footing, but Brickell Avenue is oversupplied for the foreseeable future.

Houston and Dallas are riding the crest of a reinvigorated Texas economy. Historically, there has been active migration between Texas and California, and the population and employment flows are moving eastward for the time being.

While still ranking below the national median on the Momentum Index, Texas' two largest office markets are starting to come back. Both metro areas are projected to see 2.5% office job gains as an annual average through the end of the decade, good news since their occupancies remain below 80%. Dallas, unfortunately, may be the worst case of the disparity between a troubled CBD and its recovering suburbs. Call these markets wild cards for the later '90s.

Austin, the state capital, is the Lone Star State's standout market, with a Momentum Index score of 154. Occupancy is 86%, with a robust 2.9% annual expansion forecast as the government-university-technology axis drives demand. San Antonio, a prime NAFTA beneficiary, is posting a Momentum Index score of 125 as 14,000 projected new office jobs make material inroads on the MSA's four million vacant square feet.

Slow but steady progress in Denver marks its rise to a Momentum Index score of 118. Vacant space in this 56-million-square-foot market is now less than 15%. Landauer sees the potential for the 266,000 office workers here to jump near the 300,000 level by the turn of the century. Like Austin, Denver could become a leading center for emerging technologies, catalyzing research by tapping its venture capitalists, academicians and entrepreneurs.

Well-balanced submarket conditions make Minneapolis-St. Paul an exception to the "hole in the doughnut" stereotype of declining CBDs. Both downtown and the suburbs are approximately 88% occupied, and demand has flourished across the board. With a Momentum Index rank of 153, but little current evidence of upward repricing, Minneapolis may offer capital appreciation potential.

Elsewhere in the Midwest, Chicago's suburbs have taken the lead in raising its metropolitan occupancy to 82%. Such statistics remind us not to become too giddy about near-term prospects. Chicago's Momentum rank of 73 means that, even with more than 60,000 new office jobs forecast, progress toward single-digit vacancies will require patience. Class A properties are in striking distance of recovery. Older ones could languish for years.

America's recent capital goods boom has acted as a fulcrum for economic lift in St. Louis, Cleveland and Pittsburgh, leading to a burst in occupancy rates of more than 2% in one year. Slower GDP growth and higher interest rates will moderate expansion prospects, leaving them below the national median on the Index. Services -based office markets, especially Columbus, have superior outlooks.

Trolonged economic shrinkage means that California's office markets face a long road back to health. Most are still at the lower levels of market quality. Los Angeles' Momentum Index score of 76 rates it only 44th among the 60 cities evaluated. Submarkets linked to the entertainment industry have the best near-term prospects. Orange and Riverside, the suburban counties south and east of L.A., face an arduous economic restructuring due to the shrunken defense industry. San Diego appears to have the best five-year prospects. Our forecast calls for 28,600 additional office jobs here, pushing the current 18% vacancy down into single digits by 1999.

The Bay Area offers a brighter picture, albeit pedestrian by historical standards. San Francisco and Oakland are in striking distance of single-digit vacancies, the result of decisive absorption even in the difficult past two years. A more favorable prognosis for Pacific Rim-oriented finance and trade activity should propel these markets into the upper ranks. For now, they bear Market Quality Ratings at or just above the national median. San Jose is facing stiff competition from other technology-oriented markets. The diversion of demand from Silicon Valley brings its Momentum Index score to a weak 72.

Both the Pacific Northwest and the Intermountain states are capturing shares of that diverted demand. Excellent quality of life, coupled with lower business and living costs, has attracted firms from expensive, congested California. Portland ranks third among the 60 markets in our analysis. Its Momentum Index score of 173 reflects a current metro vacancy rate of 9% and a projected increase of 17,000 office jobs by 1999. Seattle should see sufficient new demand to spark construction by decade's end.

Salt Lake City stands atop the Momentum Index with a score of 184. Both the CBD and suburban markets are more than 90% occupied and Landauer projects office employment growth of 2.5% annually. Technology and business services are the keys to demand. The major risk factor here is the ability to maintain reasonable underwriting standards as developers besiege the banks for office construction loans, a prospect that now seems inevitable.

As long as net absorption outruns construction, and we believe that will be the story at least through 1997, the psychology of the office markets should become progressively more optimistic. In fact, investor enthusiasm may outrun market fundamentals. This bodes well for price recovery, if not for near-term ROI. The extraordinary capital appreciation potential in this property type is once again becoming a factor. Landauer sees most of the risks having been squeezed out of office investments since 1990, and a high probability of success for those acquiring quality assets in 1995.

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