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Trouble Ahead for Office Market?

Office investors have had plenty of reason to celebrate of late. Soaring construction costs have kept new supply in check while effective rents in the third quarter shot up by 2.3%, the biggest hike in six years, reports real estate data firm Reis. The national vacancy rate is also falling, now registering 13.5%, down from 15.1% a year ago.

But the U.S. economy is emitting mixed signals. The number of non-farm payrolls increased by just 51,000 in September after climbing by 188,000 in August. The September tally also registered well below Wall Street expectations. A median estimate of 23 economists polled by Dow Jones Newswires in August had projected an increase of 125,000 jobs in September.

And now there's more cause for concern. While the national office sector recorded roughly 16 million sq. ft. of net absorption in the second quarter, absorption slowed to 10.7 million sq. ft. in the third quarter. Net absorption — defined as the percentage change in the amount of space taken by tenants from one quarter to the next — is the strongest indicator of tenant demand.

Weaker demand for office space driven by efficiency-minded tenants could dampen this recovery in the coming months, say industry experts. “The fourth quarter could be a real turning point for the office market,” says Sam Chandan, chief real estate economist at Manhattan-based Reis.

“The consensus is that 2007 will bring slower economic growth than 2006, which may go down as a banner year for the office market.” Second-quarter GDP registered 2.6%, down from 5.6% in the first quarter.

“These absorption numbers are a cautionary note,” warns Chandan. “But when you also consider that many well-respected economists believe that 2007 will bring a recession, it could make it even tougher for the [office] market to recover.”

Many corporate tenants are controlling their occupancy costs more effectively today than they have in the past. Instead of aggressively expanding into new space, many are simply backfilling space they already lease. Eric Bowles, director of global research at corporate real estate association CoreNet Global, believes that this newfound efficiency will directly impact net absorption.

“We've seen the average amount of space per [office] worker drop over the past few years,” says Bowles. “The mantra among big office users is simply to use their space in a wiser and more efficient way.” When companies relocate today, they are typically downsizing from an average of 250 sq. ft. per worker to 175 sq. ft., according to CoreNet Global.

Nortel Networks is a fitting example. When the Canadian telecom giant relocated to new office headquarters in Toronto last year, the company reduced the average amount of space it allocates per worker from 376 sq. ft. to 199 sq. ft. Nortel moved 3,875 workers into the Toronto tower.

“Many companies have become notoriously good at using their office space more efficiently,” says Bowles of CoreNet. “Many large tenants simply don't have the need to expand their footprint.”

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