OFFICE LEASING STRONG IN SPITE OF ANEMIC JOB NUMBERS

Randyl Drummer, CoStar Group

Lease Deals Inked As Office Tenants Take Advantage of Lower Rents in Prime Buildings; 'Phantom Space' and Weak Job Growth Keep Lid On Net Absorption

Despite slower-than-expected job growth and the uncertain impact of the debt-ceiling issue and overseas economies, office leasing remained very strong in the second quarter of 2011 as office-occupying businesses continued to gradually add workers and absorb space.

Preliminary second-quarter CoStar data shows that bargain-hunting tenants are trading up to larger and better buildings, taking advantage of concessions and asking rents that average 10% lower than their 2008 peaks.

Driving that demand is the expectation that, should more robust job growth resume as expected, office rents could be poised to increase ahead of demand growth as the shutdown in new development has curtailed any meaningful new supply.

Brisk gross leasing activity continued in the second quarter at an expected 120 million square feet -- well above the average of 90 million square feet over the last few years and up a robust 60% from the market bottom in 2009, according to data presented at CoStar Group’s Mid-Year 2011 Office Review & Outlook.

The national office vacancy rate edged down slightly to 13.3% at mid-year from last year's cyclical peak of 13.6%. The percentage of CoStar submarkets with declining vacancy rates, an important leading indicator of office market health that dropped several percentage points in the first quarter, began trending back up in the second quarter.

Class A asking rents across the U.S. stood at an average $27.50 per square foot at the end of the second quarter, down from $30.50 per square foot in mid-2008, with concessions knocking off an additional 10%-20% from the cost of occupancy. As rents decrease and terms become more flexible, tenants are increasing or upgrading their space, said Andrew Florance, CoStar founder and CEO, who led the presentation of the latest quarterly data.

The second quarter saw the fifth consecutive increase in net absorption of office space. However, the gain was very modest due to faltering growth in jobs over the last two months exacerbated by an abundance of 'phantom' space from prior layoffs.

In the previous recovery cycle in commercial real estate from 2003 until the downturn in 2008, each new job added to the office-occupying workforce created an extra 233 square feet of demand for office space. The current recovery has brought demand for just 88 square feet of added space per new employee, Florance said.

"We’re sort of in the doldrums right now. The only thing driving net absorption is bargain hunting," Florance said. "It will be pretty difficult to find super strong absorption numbers the next quarter or two."

The U.S. economy hit a soft patch last quarter, with the debt ceiling debate and other fiscal issues undermining business confidence and most indicators continuing to disappoint analysts over the last eight weeks.

However, business investment in IT and technology are creating strong real estate demand among tech companies, and the office-dwelling professional and business services segment is seeing the strongest employment growth, generating one-third of all new hires. Other sectors showing gains are education, health services, trade and manufacturing, and leisure and hospitality.

Losses in public sector jobs have partially offset those gains, with the private sector adding 2 million jobs over the past year while total job growth is closer to 1 million due to reductions in government payrolls, mostly at the state and local level, with some at the federal level as well.

Lower Rents Spur Leasing, Absorption
Houston logged the strongest year over year net absorption at 2.5 million square feet, although landlords lowered average rents in that market by 2.4%. Landlords in the technology-centered San Francisco Bay area raised rents by nearly 4% but still achieved an increase of 2 million square feet in absorption.

Other top markets that dropped rents and saw absorption increase include Seattle/Puget Sound, Philadelphia, Boston, South Florida, Orange County, CA, and Dallas -- all of which had modest absorption gains of around 1 million square feet.

Absorption was down about 1 million square feet in New York City, where owners have aggressively raised rents 7.3% year over year and cut discounts.

Class A buildings enjoyed the strongest net absorption, with many Class B and C tenants trading up for better quarters.

If robust job growth projections by Moody's Economy.com come to pass and the nation avoids a fiscal crisis due to government default, the national vacancy rate could fall to a phenomenal 8.5% by 2015 amid diminishing supply, according to CoStar forecasts. Those same factors could push rents up by more than 12% annually within four years.

"Markets continue to regain their footing as a result of the combination of tenants looking to capitalize on favorable lease rates and construction that is at 40 year lows," adds Chris Macke, senior real estate strategist for CoStar. "The rate of recovery going forward in the office sector will depend on how aggressive corporations are in their hiring activities."

In investment sales, the second quarter saw a big uptick in sales volume, roughly back to 2006 levels. While core investment-grade properties are seeing some price appreciation, prices remain soft in general-grade commercial property. However, this year could be the tipping point on overall pricing. Prices per square foot in several large metros in 2011 are exceeding their historical averages in such markets as Washington, D.C., San Francisco, Seattle, Boston, Denver and Orange County, CA.