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U.S. Office Market Enters Early Recovery as Absorption, Demand Point Up, Vacancy Turns Corner

While Recovery is the Trend Nationally, Local Markets Catching Up Sporadically
October 13, 2010
The office market recovery has begun -- although it may not feel that way yet in every market across the country.

The theme of CoStar Group's 2010 Third Quarter Office Review and Outlook released this week was both simple and direct: "We are in early recovery for the office market," said Andrew Florance, CEO of CoStar Group in the company's webinar presentation.

CoStar confirmed that in the third quarter the U.S. office market posted positive net absorption for the second consecutive quarter -- 5 million square feet absorbed in the second quarter and 7 million square feet in third quarter.

However, CoStar's research also made it evident that the recovery has been anemic so far and is still very early in the process. CoStar is projecting that the national office market won't begin seeing rental rate increases for another three or four quarters or net operating income increases for another four to six quarters.

The fact that the U.S. office market posted positive office employment growth for a consecutive quarter is a first positive indicator that recovery is beginning to take hold, despite high unemployment levels and continued layoffs. In the past two quarters, approximately 24,000 and 8,000 office-using jobs respectively have been created, according to U.S. labor statistics.

That growth has led to a second positive indicator of office recovery -- the strength of the leasing activity.

"Leasing activity in the quarter was healthy and robust," Florance added. "We're now seeing the strongest leasing activity numbers we have seen since the peak of the market [in 2005 and 2006]."

"Tenants are no longer staying on the sidelines to wait for a better deal. They are trying to move in to capture better deals," Florance said.

In its third quarter analysis CoStar also noted the historically low level of new office supply as a third positive indicator for the office sector.

"Office deliveries in the United States remain stunningly low, historical all-time lows," Florance said. "We're down 85% right now in deliveries [from historical averages]. When you look at new construction starts, we're running at about 3 million to 4 million square feet of new construction starts for office space in each quarter in the United States. That is well below what is required to replace depreciating inventory."

Florance estimated that the inventory of existing office space is contracting by about 75 million square feet of space per year.

"If you have positive absorption and contracting supply, that is going to imply decreasing vacancy rates," Florance said.

CoStar is showing that the U.S. office vacancy rate is clearly moving down and declined slightly in the third quarter to 13.62%. The amount of availability also was in decline from 17.7% to 17.6%. (The availability amount includes space that is occupied but also on the market.)

"This means we are no longer in a deteriorating market," Florance said, "and the balance is shifting ever so slightly but consistently from being a tenant market to a being an owner market."

However, it office market conditions can be a very different story from market to market around the country.

"We're excited about a 30 basis point improvement in vacancy rates at the same time that people may be out there struggling to lease a property in Orange County or Phoenix. What we're saying about recovery may not foot with what many may be experiencing right now in the actual leasing marketplace," Florance said. "But [declining vacancy] is a leading indicator and it is a clear indicator; it means that ultimately conditions are improving, but it doesn't mean that things are uniformly better everywhere."

In conjunction with the release of third quarter office numbers, we sampled brokers across the country to find out what they are experiencing in office leasing activity in their markets.

Boston: "The lifeblood of the Boston market is its knowledge-based sectors, and those innovative companies which by definition start small, then grow," said Mary Sullivan Kelly, senior vice president and chief research officer for Colliers Meredith & Grew. "I can tell you that anecdotally, we are seeing growth from a number of firms -- particularly small and mid-sized tech and life science firms, some increasing their space requirements marginally, some by 50% or more, and this is an encouraging sign. From where we stand right now - fourth quarter 2010 - it is going to take some time for this to impact the vacancy and absorption stats, but still, I believe bodes well for 2011 and beyond."

Atlanta: "What I can tell you is merely anecdotal, but with our clients (almost exclusively small to mid-sized local and regional firms) I am seeing tenants focusing on budget impact above all else," said Rob Hill, commercial brokerage sales and leasing with Hill Corporate Partners. "When money was cheap and credit was easy, landlords were able to compete based on creating efficiency for the tenant through reconfiguring their space - giving the tenant "more bang for the buck.'"

"Today, while money may be cheap, credit (along with collateral) is nearly nonexistent. This leaves the tenant to face either paying for tenant improvements themselves or adjusting their business practices to fit an existing layout," Hill added. "Paying for tenant improvements, from a practical standpoint, requires a longer term to justify (and depreciate) the expense. Unfortunately, in today's world, five years can easily see a company's whole business strategy change."

"Add to this the uncertainty and potentially costly changes brought about by the anticipated elimination of balance sheet distinction between capital and operating leases (including renewal and expansion options), and it isn't surprising that market data is hard to get and harder to interpret," Hill added. "In essence, there seems to be a shift from more thoughtful, proactive planning and execution to an approach that avoids commitments under rules that seem destined to change in ways that are as monumental as they are unclear - and this goes as much for landlords as it does for tenants. The name of the game today - and if current trends continue, for a long time to come - is survival and maintaining as much flexibility as possible. Everyone has gone almost totally defensive."

New York: "What I am seeing in the office leasing market is smaller tenants getting lower renewal rents (dollars per square foot), taking less square feet be it renewed or tenants consolidating, and landlords doing more tenant improvements," said Adelaide Polsinelli, associate vice president investments for Marcus & Millichap. "Larger tenants are doing the same as smaller tenants except they are taking advantage of the lower rents and taking on more space in buildings where they want to stay for a longer time."

"The trend seems to be that for tenants who believe we are at or around the bottom, they are taking advantage of opportunities that will enable them to expand in the future if they are a large tenant, and to reduce their overhead if they are a smaller tenant," Polsinelli said.

Austin: "Caution is the word with tenants - new tenants and renewals," said Luke Wood of Cantex Realties LLC "Current tenants are waiting longer to renew and heavily scrutinizing space needs. In years past, our large tenants would usually absorb space for expected expansion. Now, those tenants are not only giving back that space, they are cutting existing space to the exact need of today."

"Startups are signing short-term leases; stable, credit tenant's want to lock in long-term low rates," Wood said. "Rates are down. Most quoted rates are $1.50 - $2.00 above the effective rate deals are being signed. Sublease space is finally being absorbed, resulting in more direct deals for landlords. Leasing activity has been steady. Deal flow has been consistent with years past; however, tenant's expectations have changed."

Phoenix: "The Phoenix metro area is driven by construction and housing expansion," said Rick Mineweaser, president / designated broker of Diamond Pacific Investments, adding, "and that industry is comatose. Not until housing stabilizes and picks up will this area really start to recover. Markets like Phoenix provide a real sense of the effects of phantom occupancy, where much of the occupied space (space paying rent) is vacant or underutilized."

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