Office Recovery: One Uneven Race

2005 was a year of recovery for the office sector, and most industry sources expect more of the same as the New Year unfolds. Analysts caution, however, that the resurgence will not be uniform as market gains will be sharply divided between coastal cities and nearly everything in between. Widely divergent capitalization and vacancy rates are the most palpable sign of this bifurcated market, especially between markets such as Manhattan and Detroit.

“The pricing gap between coastal markets and everything else is huge and growing,” says Ross Moore, senior vice president and director of market research at Boston-based Colliers International.

Many inland markets are still reeling from the decline of the manufacturing economy. Vacancy rates in Detroit, for example, increased from 13.8% at midyear to 15.9% at the end of October. The prospect of raising rents — and returns — in such markets is challenging. The reason, says Moore, is that most inland office markets cope with price-sensitive tenants and investors. That’s not to say that rising rents aren’t pinching many Manhattan and Los Angeles tenants, but Moore says there’s a difference.

In places like Manhattan — where midtown vacancy rates hit 6.9% in December, the lowest since early 2000 — landlords have no qualms about raising rents now. Indeed, the media and financial-services companies that dominate those markets have little choice. “Look, if you work in the entertainment business you really have to be in Los Angeles. The same goes for global finance firms that have space in Manhattan,” Moore says. “These tenants need to be there, and investors and landlords are pricing that into their deals.”

Demand has pushed purchase prices for Class A office space as high as $59.64 per sq. ft. in Manhattan. Overall, according to Real Capital Analytics, the average capitalization rate on all Northeastern office sales above $5 million was 7% during the first 11 months of last year. Yet average caps in the Midwest increased to 8% during that period.

As climbing cap rates suggest, the Midwest market appears to be softening as the Northeast continues to strengthen. Since November, the average cap rate on office properties offered in the Midwest climbed to 8.1% and fell to 6.5% — or 50 basis points — in less than one month in the Northeast.

Another factor in the coastal boom is rampant condo conversion activity. Condo converters were the largest net buyers of commercial property in 2005, and they didn’t just gobble up apartment buildings: Real Capital Analytics reports that converters gobbled up more than 12 million sq. ft. of office, industrial and retail properties — and the bulk of that total was office space.

While there may be more opportunity for “value-added” investing inland, few investors are willing to make that bet. And, in many respects, they are taking their cues from tenants. “The coastal markets, by and large, are deemed the place to be right now for investors and tenants,” says Richard Brown, senior real estate partner at Manhattan-based law firm Herrick, Feinstein. The firm leases office space in Manhattan and New Jersey and has signed three new leases in the past year at each location.

“These are all expansions because we’ve had to hire so many new attorneys to keep up with demand,” he says. “It’s really a function of the economics in these cities,” he says. “You may not have many options as a tenant, but it’s simply not an option to move somewhere else to find cheaper vacant space.”

What’s more, few sources expect office rents to stall in these key markets. Moore of Colliers sees a handful of markets such as Manhattan, Washington, D.C., South Florida and Southern California acting as the catalyst to push rents “significantly higher” in 2006. He even sees a strong possibility for rent spikes in these markets, not to mention intense bidding for office space.

“We are well aware of the challenges that the U.S. economy faces as we enter 2006,” says Moore. “But we also believe that because so many businesses are well-capitalized and financially secure, they are primed for expansion. There will be pockets of pronounced tightening in the market, and we expect most of that to be on the coast.”

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