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Office Steals Tantalize

But behind the alluring bargains lie hard realities of damaged fundamentals.

Across the country, office properties are for sale at sizzling discounts compared with prices of just a year ago. But whether investors have the cash and fortitude to consummate deals in today's still-shaky economic environment remains to be seen.

All but three of the top 20 markets recorded year-over-year price declines through September. The steepest drop, a jolting 58.2% plunge, shook the Westchester, N.Y.-Southern Connecticut region, according to Bethesda, Md.-based research firm CoStar Group.

When it comes to price gains, however, the leader is none other than long-suffering Detroit, whose office market reflects a litany of problems with the ailing auto industry. Sales prices in metro Detroit rose an encouraging 7.7%, although buildings are still cheaper than in most big markets, at $66 per sq. ft.

Compare that with Denver, where sales ring up at $155 per sq. ft. The costliest market, of course, is New York, at $449 per sq. ft., followed by Washington, D.C., at $338 per sq. ft., CoStar reports.

As they study the falling prices, investors must weigh the advantage of lower cost with the dynamics behind the decline — namely deteriorating fundamentals.

Effective rents fell 2.2% in the third quarter, with far more dramatic year-to-date change. This year's precipitous fall in effective rents “is a magnitude unseen in 14 years,” says Victor Calanog, director of research for New York-based data firm Reis.

Amid rising unemployment and weakening demand for space, the U.S. office vacancy rate rose to 13% in the third quarter, according to CoStar. But according to statisticians' forecasts, vacancy could shoot to 19% if companies consolidate their space to reflect smaller workforce levels.

The nation's unemployment rate climbed to 10.2% in October. But the statisticians explain that the office vacancy rate has not yet risen to the level projected given the job losses. The gap stands at six percentage points, notes CoStar.

“We call it phantom vacancy. Phantom vacancy can mute any recovery that we do see down the road,” says Jay Spivey, senior director of analytics at CoStar.

Vacancy expected to peak in 2010

Barring a sharp adjustment for the layoffs, the office sector currently is on track for vacancy rate to peak in the third quarter of 2010 at about 16%. But it could take two more years, until the third quarter of 2012, before excess supply is absorbed and rents finally rise.

In the first quarter of 2009, negative net absorption approached 20 million sq. ft., far less than the projected 130 million sq. ft. analysts expected. In the third quarter, negative net absorption of 25 million sq. ft. was forecast based on job losses, but negative 13 million sq. ft. was recorded.

One reason space has not yet been consolidated is that many leases have not yet come up for renewal. And some tenants hang on to prime space in anticipation of growth. “If they're laying off workers, it might be that in their office every fifth desk [is] sitting empty,” says Spivey.

If thousands of tenants jettison unused space, landlords would lose billions of dollars in rental income. Cities whose vacancy rates already are soaring would be hit hard. In the third quarter, metro Phoenix recorded the highest vacancy rate at 21%. Dallas and Atlanta metros registered 17% after building sprees.

Class-A deals

Financially distressed properties have flooded many markets, driving some lease rates back to levels not seen for 20 years, and jeopardizing the livelihood of market-rate owners who can't compete with bargain rates.

But there's a flip side to distress. “There's a tremendous opportunity to buy. We're seeing Class-A properties being sold for under $100 per sq. ft.,” says Scott Marcus, principal of RSM Development & Management, an owner and developer of medical office properties based in Bloomfield Hills, Mich.

One impressive building, the Columbia Center in Troy, “probably one of the nicest buildings in the market,” is selling for less than $100 per sq. ft., says Marcus. Three years ago, it would have sold for $160 to $200 per sq. ft. A 200,000 sq. ft. building sold for $5 million, a fraction of the price similar properties once commanded.

Today's investors are strictly regional, says Marcus. “We're not seeing any institutional buyers. They've all left.”

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