A Supply Glut In the Office Sector

Over the past two years, as office markets softened, industry pundits predicted that things would not get as bad as they did in the last recession because this time the market was not overbuilt.

It looks like they were wrong. A wave of CBD development begun in the late 1990s will soon dump more than 20 million sq. ft. onto Chicago, Boston, New York and Washington, D.C. This additional space, combined with an already high double-digit vacancy rate and a nationwide sublease glut, could further depress rents and delay a full-fledged office recovery.

“The demand was there when developers started these projects, but now the national office vacancy rate is approaching 1992 levels,” says Bob Bach, national director of research for Grubb & Ellis. In 1991, overall national office vacancies reached 18%, less than one percentage point higher than where it stands now. In both Chicago and Boston, he believes, new projects nearing completion will only exacerbate vacancy woes.

“Nowadays, the office market isn't as overbuilt as it was in the early 1990s, but nowadays anything delivered to the market is too much,” says James Costello, a senior economist with Torto-Wheaton Research. National office supply will expand by 4% as a percentage of overall stock this year, based on Torto-Wheaton data. The last time the market posted a 4% increase was in 1991.

One positive sign: unlike the new supply that crippled real estate markets a decade ago, much of this new space is pre-leased. But in a fickle economic climate that has seen anchor tenants like Arthur Andersen dissolve, no credit tenant's leasing commitment is set in stone. The former accounting titan terminated its lease in one of the nation's biggest office projects — Boston Properties' Times Square Tower, slated for May 2004 completion. The 1.2 million sq. ft. building now is only 17% pre-leased, reports CoStar Group.

Across town, Brookfield's new 1.2 million sq. ft. tower — 300 Madison — is dealing with a similar problem. Anchor tenant CIBC decided in January to market more than 800,000 sq. ft. of its new space as sublease. And in February, Phillip Morris announced its decision to vacate its longtime headquarters just one block east of 300 Madison. That decision is expected to dump more than 700,000 sq. ft. onto the Midtown market.

“We won't see lower levels of new product coming on line until 2005 or 2006, and much of the new product we are seeing now was started during the last boom,” says Maria Sicola, senior managing director of research at Cushman & Wakefield. With several office markets posting over 20% vacancy, Sicola believes that new product can only exacerbate the problem, unless strong absorption kicks in.

Manhattan-based brokerage Colliers ABR reports that lease expirations nationwide will increase over the next three years as long-term deals signed in the mid-1990s expire. Tenants who moved into brand-new buildings between 1991 and 1993 may choose to relocate entirely once their lease term expires. The final variable — turnover supply — will pit existing space (much of it vacant or subleased) against new space. Without steady demand, the new space could drag the market down and keep rents in the doldrums nationwide.

Construction Pipeline in Four Major Markets
NYC D.C. Chicago Boston
Total Bldgs Under Const.* 6 41 34 24
Total Sq. Ft. of New Product 5.4 million 9.8 million 3.7 million 4.4 million
Pre-Leased (Total) 59% 59% 71% 64%
Total CBD Inventory 288 million 117 million 146 million 67 million
CBD Vacancy 9% 8% 15% 11%
*The total of 105 projects are scheduled to be completed between March 2003 and June 2005.
Source: CoStar Group

Net asking rents for Class-A, CBD space averaged below $18 per sq. ft. at the end of 2002, according to Boston-based Torto Wheaton Research. This average peaked in 1999 at $20 per sq. ft., a sharp rise from the 1996 bottom of $14 per sq. ft. Nationwide CBD vacancy for Class-A office space now stands at 14%, reports Cushman & Wakefield.

Where will the glut hurt the most? “It's likely that Chicago will be overbuilt by the beginning of 2005, and until then we'll see vacancy creep up,” says Michael Bishop, senior vice president at Chicago-based brokerage Equis. As pre-leased new construction draws tenants from existing buildings, Bishop sees vacancy rising among Chicago's older office stock. Chicago's CBD is posting 15% vacancy.

Meanwhile, one large office project in Boston and another in Washington, D.C. are about to be completed without tenants. Boston's 33 Arch Street, a 607,937 sq. ft. office building, is scheduled for completion in January 2004, while Washington, D.C.'s 416,014 sq. ft. One Metro Center will also hit the market in August without tenants, reports CoStar Group. “Anything that we can do to keep the supply side in balance helps, given such weak demand,” says Cushman's Sicola. “The only way out of this [depressed office market] is aggressive employment growth that will drive the vacancy rate down to equilibrium.”

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