Warning Sign For Office Market?

It’s tough to argue that the health of the nation’s 7 billion sq. ft. office market is anything but robust. Demand is strong and vacancy rates have fallen. Lofty construction costs have tamped down new supply and asking rents shot up at their fastest rate in six years during the third quarter.

But a host of economic risks, ranging from weak job growth to ripple effects from a housing slowdown, could impact the office market in coming months. The shift may already be upon us: Take third-quarter job growth, which many economists viewed as mediocre -- non-farm payrolls increased by just 51,000 in September after rising by 188,000 in August. The consensus prediction among 23 economists polled by Dow Jones Newswires was that payrolls would jump by 125,000 in September.

While recessions are notoriously difficult to predict, some troubling signs have emerged in recent months. One quirky example is the Federal Reserve’s “beige book” report from September.

This closely watched survey, essentially a roundup of regional economic reports, used the word “weak” 50 times. The July report only featured 40 references to “weak.” What’s telling is that the January 2001 report used the word 53 times and that was two months before the last recession officially began. One real estate economist believes that the office market is slowly feeling the effects of weaker job growth.

Leasing demand answers to job growth. So will this be a gradual slowdown or a flat-out recession? The Conference Board, a global research and business membership organization, reported on Tuesday that several economic indicators suggest slower growth --but not a recession -- on the horizon.

Within the past three months, the Conference Board’s index of leading economic indicators has turned down relative to its level six months ago. That’s significant because it marks the first time that the index has fallen since the current economic expansion began in 2003.

“While this signal is not particularly alarming, since the downturn is still rather modest, it does suggest that the economic cycle is more mature than is generally presumed,” says Gail Fosler, executive vice president and chief economist at the Conference Board.

“Everybody is watching the job numbers and the housing market very carefully,” says Bob Bach, national director of market research at Oak Brook, Ill.-based Grubb & Ellis. “It’s also getting harder to deny that growth has pulled back a bit given the recent job numbers.”

Sam Chandan, chief economist of research firm Reis, points to a more troubling sign of a slowdown: Net absorption fell from 16 million sq. ft. nationally in the second quarter to 10.7 million sq. ft. during the third quarter. That means tenants are taking on less space and demand is cooling.

“The fourth quarter could be a real turning point for the office market,” says Chandan. “And the consensus is that 2007 will bring slower growth than 2006, which may go down as a banner year for the office market.”

And what about a severe slowdown in the housing market? History offers some guidance: If the housing market were to reprise its last major downturn in 1991, Bach projects that roughly 716,000 payroll jobs would be lost. That total represents 42% of all net additions to non-farm payrolls by all sectors between August 2005 and August 2006.

More than 90,000 of these jobs would be in housing-related service sectors that tend to occupy office space. The upshot is that such a severe slowdown could generate negative net absorption approaching 16 million sq. ft. over the next four quarters. But, Bach adds, that is a “worst-case scenario.”

It’s important to note that most of the bearish economic forecasts in recent weeks have all touched upon a housing slump. Last week, for example, International Strategy & Investment economist Nancy Lazar said this in the Wall Street Journal: “I'm very worried about housing and the potential negative impact on overall economic activity...the big question for me is how will that impact consumer spending?"

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