The sector specter: office and apartments

RMA Journal, The, June, 2004 by Lloyd Lynford

The Office Market

March's employment report of 308,000 new jobs is certainly welcome. It is also the first suggestion that the nascent economic expansion may become self-sustaining. At the same time, Reis's first-quarter data on the U.S. office market suggests that the salutary effects of job growth are not yet translating into tangible benefits to office investors.

Too little, not soon enough. The return to positive job growth, which began last September, has been of insufficient duration and magnitude to restore robust absorption, commercial real estate's measure of demand, to the U.S. office market. Reis's first-quarter numbers on the top 61 metropolitan markets are in, and the aggregate results indicate that the U.S. market was unable to build upon the progress that was recorded during 2003's fourth quarter. Only 1.5 million square feet of space were absorbed during the first 90 days of the year, down from the previous quarter's total of 4.1 million square feet, And while any positive absorption is preferable to the alternative, it is clear that the market has barely begun the long march toward equilibrium. Moreover, these extremely modest levels of demand were essentially "bought," meaning landlords lowered their rents and upped their concessions to entice tenants to renew or sign new leases. Clearly, the fundamentals of supply and demand remain, in most metropolitan markets, challenging for owners.

Effective rents dropped by 0.7% during the first quarter, the same rate of decline recorded in the previous quarter. Since their peak in the first quartet of 2001, effective rents are now down 21.0% to an average of $20.29 per square foot. Many observe that the current downturn in the national office market is not as severe as what was experienced during the early 1990s. And while it is true that the vacancy rate has not climbed to the 19.0% level recorded between 1986 and 1992, the pace at which rents have fallen has exceeded that of the earlier downturn. Coupled with 10 out of 11 quarters of negative absorption between early 2001 and 2003, it is not unreasonable to conclude that the downturn of 2000 to 2004 may feel as agonizing to many investors as did the correction of the late eighties and early nineties. Further, many metropolitan markets have suffered rent declines dramatically exceeding the U.S. average. In San Francisco, for example, effective rents are down 59.2% from their peak; San Jose (down 56.9%), Boston (41.8%), Oakland (33.1%) and Austin (31.9%) have all experienced massive rent reductions.

Despite the anemic pace of net absorption, one subtle but favorable signal from Reis's first quarter data is that the national vacancy rate declined for the first time since its ascent commenced in the third quarter of 2000. While the 10-basis-point drop to 16.8% might seem unremarkable, we believe that the vacancy rate, given anticipated levels of office completions and absorption, is now on a gradual downward slope. It is precisely the shape of that slope that all participants in the office market must constantly endeavor to measure.

What's needed? Many questions about the future of the U.S. office market are begged by current conditions. Of primary importance: What level of job formation is required to generate sufficient levels of demand to place pronounced downward pressure on the vacancy rate and prop up falling rents.

Second, is the traditional link broken between output and employment; can investors in office buildings count on cyclical economic recovery to restore relative predictability to the pace at which office space is leased?

Context is important in addressing the first question. Since September, employment growth has averaged just over 115,000 new jobs per month. Given that the economy must generate approximately 150,000 new jobs monthly just to keep pace with the nation's population growth, it is clear that the current pace of job formation must be categorized as inadequate.

The second question--will robust GDP growth translate proportionally into new jobs?--is more difficult to answer. If the well-documented gains in productivity continue, and if they are more beneficial to the dominant office-using industries (given these industries' heavy reliance on technology) than to the economy generally, will companies be able to expand their businesses without a concomitant surge in hiring? And even if the answer to that question is no, it appears that companies are allocating fewer square feet per employee, Other factors introduce even more uncertainty regarding the relationship between employment growth and office demand: overseas oursourcing of jobs in the business and financial services sectors (the negative implications of which remain unclear but are likely overstated), the shrinking workstation, the ongoing impact of rotational use of shared office space ("hoteling"), home offices, and competition from shadow space already attached to existing leases. Some of these factors may not be material, while others are more so than we presently recognize, However, their combined impact may mute the level of future office demand traditionally associated with strong employment growth.