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Report: Office Fundamentals Weaken in Second Quarter

The U.S. office vacancy rate climbed in the second quarter amid decreasing demand and new deliveries of space, according to research by Colliers International. Downtown rents showed modest increases but suburban office properties have begun to feel the impact of the slowing economy as those rents edged downward.

Nationwide, the office vacancy rate in the second quarter jumped 27 basis points from the previous quarter to 13.24%, marking the third consecutive quarterly increase in office vacancy. Driving that trend are both decreasing demand and increasing supply, according to Ross Moore, executive vice president for market and economic research at Colliers International.

Absorption went negative in both quarters during the first half of this year, which means office users vacated more space than they leased. Second-quarter office usage contracted by 1.4 million sq. ft., Colliers found, in stark contrast to the 21.2 million sq. ft. of absorption recorded a year ago. Since the first of this year, tenants have returned 5.1 million sq. ft. back onto the office market.

“In the fourth quarter of 2007 we had positive absorption but unfortunately we had more new supply, hence a rise in vacancy,” Moore says. “This year, there’s negative absorption and lots of supply.”

How much new supply? Second-quarter office completions pumped 19.4 million sq. ft. of space into the market, on the heels of 17.3 million sq. ft. of construction in the first quarter. The pace of construction is up from a year ago, too, when deliveries amounted to 18 million sq. ft.

While new deliveries aren’t helping fundamentals, the chief cause of increasing office vacancy rates is faltering demand, according to Josh Scoville, director of strategic research at Property & Portfolio Research. Preliminary second-quarter data of the 54 markets tracked by the Boston-based research firm show 2.2 million sq. ft. of positive absorption, marking a change from nearly 1.9 million sq. ft. of negative absorption in the first quarter.

“Absorption of 2.2 million sq. ft. for the country overall looks like an improvement over the first quarter, but that’s really weak,” Scoville says. The economic weakness that is pervading the country is keeping the demand for real estate relatively tepid.”

PPR’s preliminary numbers show wide variations in individual markets, with significant negative absorption in metros that have suffered the most from the downturn in housing. Office users in Tampa, for example, returned 602,000 sq. ft. to the market in the first quarter and vacated another 270,000 sq. ft. in the second quarter. It’s a different story in Houston, where the thriving energy sector helped drive more than 1.5 million sq. ft. in positive absorption in the second quarter, PPR found.

“But even the big financial markets like New York and Chicago are seeing space given back by financial companies,” Scoville says. PPR tracked 2.6 million sq. ft. of negative absorption in the Big Apple during the second quarter, while Chicago office tenants absorbed 961,000 sq. ft. in the second quarter but vacated nearly 1.9 million sq. ft. in the first quarter.

Colliers identified contrasting office performance in central business districts compared with suburban markets, although vacancies increased in both. Downtown vacancy rates climbed 34 basis points from the previous quarter to register 11.27%. Suburban vacancy rates increased 23 basis points in the same period to 14.2%. Downtown Class-A properties saw a more rapid change with a 60 basis point climb to a 10.17% vacancy rate, while suburban Class-A vacancy increased 42 basis points to 14.26%, Colliers found.

Despite weak demand, rental rates remain up on a year-to-date basis. Downtown Class-A offices are leased for an average $50.20 per sq. ft., up 1.5% from the previous quarter and up 3.1% year to date. Suburban Class-A space is up 0.1% for the year despite a 0.3% decline to $28.70 per sq. ft. from the first to second quarters.

Office market conditions nationwide will remain weak through the rest of the year and then level off as construction completions decrease and economic growth returns-- probably in 2009 -- predicts Scoville of Property & Portfolio Research. “Don’t look for the big bounceback, but it should improve.”

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