Surging worker productivity is great news for the U.S. economy because ultimately it leads to job creation. But in the near term, high productivity gains pose a major challenge for the struggling office market: a smaller, more productive workforce means less demand for office space.

Worse yet for office owners, Corporate America is doing everything it can to lower occupancy costs by consolidating staff and investing in new technology. Since 1991, the average amount of space per worker has shrunk by roughly 14 sq. ft. and now stands at 202 sq. ft., reports Torto Wheaton Research. That figure is expected to dwindle to almost 195 sq. ft. by 2007.

“At many companies, cubicles are going from 12 sq. ft. down to 8 sq. ft. Tenants have a much clearer strategy with their real estate than they did in the late 1990s,” says Ray Torto, principal of Torto Wheaton Research.

At a minimum, what this means for landlords is a deferred recovery, but it also suggests long-term changes in demand. “The way that tenants use office space is changing radically,” says Daniel Malachuck, a senior managing director at CB Richard Ellis Consulting. “I don't think people have yet figured out the implications of the wireless office, but technology is the No. 1 issue that affects every company.”

Technology has clearly boosted productivity over the past few years. These massive productivity gains have even spread into the service sector. Economists now say that many of the nearly 3 million jobs lost during the recession simply won't be replaced. That's grim news for the national office market, which currently suffers under the weight of a 17% vacancy rate, according to Grubb & Ellis. It's hard to believe that the national office market was only 7% vacant back in 2000.

“Companies know that they can get more work out of the same person and, because of that, this will be a very slow hiring recovery,” says Kenneth Rosen, an economist at the University of California-Berkeley.

If that's too abstract to grasp, picture a 540 million sq. ft. hole the size of the Grand Canyon. That's the amount of available office space on the market today. Torto believes that the prospects of lackluster job growth, technological advancements and increased employer outsourcing will make the task of filling that hole much more difficult.

Torto forecasts the vacancy rate to dip to 13%, but not before 2007. If his forecast is accurate, that means the vacancy rate will improve by only 1% per year over the next four years. “Without real job growth, you just can't fill in this huge vacancy hole. The hose that you need to fill it is just dripping, so there's not much coming out,” he says.

Adding insult to injury is the fact that corporate layoff announcements remain rampant. Outplacement firm Challenger, Gray & Christmas reported that in October corporations announced 172,000 planned job cuts, the highest figure in four months, and a 125% increase over September. That brings to 1.04 million the number of cuts since the beginning of 2003.

A Hesitant Corporate America

Even though the U.S. economy enjoyed an explosive 8.1% third-quarter worker productivity gain, businesses are still reluctant to expand their workforce. An October survey by the Business Roundtable revealed that only 12% of the executives polled expect to grow their workforce in 2004.

Since early 2001, the economy has shed about 2.8 million jobs. And while the tide has begun to turn — nonfarm payroll employment rose by 126,000 in October — economists now say that for unemployment to drop below its current 6% level, the economy needs to add 150,000 jobs a month.

Lloyd Lynford, founder and CEO of real estate research firm Reis Inc., says spurts of economic growth may inspire short-term hiring, but that might not be enough to inspire long-term office leasing. “The result is that new hires are going to have to bunk up with each other, so to speak, while landlords wait for their share of the prosperity,” says Lynford.

“Sustained economic expansion and corporate profitability are required before decision makers feel sufficiently comfortable about the future to commit to a long-term lease,” adds Lynford.

No Office? No Sweat

The Torto and Lynford projections suggest that the office recovery will be anemic at best as firms backfill space or simply cram more workers into less space. The Santa Clara, Calif.-based tech firm Sun Microsystems, which employs 35,000 workers globally, is using technology to reduce its occupancy costs.

Sun has embarked on an aggressive campaign to decrease the ratio of employees to offices. Right now it stands at 1 to 1, but a Sun executive says the projected ratio is 1 to 0.9.

Sun is well on its way to meeting that target. “Forty-five percent of our employees operate in a flexible way as iWorkers. These employees have given up their right to an individual office,” says Bruce Shick, manager of workplace resources at Sun.

According to Shick, Sun could add 30% to its headcount without spending another dime on real estate. Like many other tech firms, Sun expanded aggressively during the late 1990s, only to be left with a glut of vacant space after the tech market meltdown.

All told, Sun now occupies roughly 8 million sq. ft. of U.S. office space. A full 60% of that total is leased, the balance of that owned. Under Sun's “iWork” program, Sun has approximately 1,000 iWorkers without offices. These employees work mainly from home, or they reserve an office in advance at a Sun office property.

The technology that enables Sun to carry out the “iWork” program is a SunRay workstation. Each computer and telephone in a Sun office terminal is outfitted with a SunRay module. If an iWorker reserves office space in advance, all he or she must do is swipe a company Smart card (this is implanted with a chip) at a SunRay in order to have an instant office. Not only does the worker's desktop appear on the computer screen, the phone at the desk will also receive all incoming calls to that employee.

Sun is one of a handful of tech firms using this new technology, but Shick believes that its applications are likely to spread to other types of businesses. “I can go to any Sunray on this campus and have an instant office. Plus, there's no IT [information technology] cost for relocating,” Shick says.

The SunRay technology poses a dilemma for landlords, who profit from groups of people routinely occupying the same physical space for years. As Sun has proven, the technology allows its workers to use space where they need it and when they need it — the same way that a hotel serves travelers' short-term housing needs.

Shick acknowledges that Sun isn't out to convert every office into a flexible work environment. But he sees this flexibility as crucial to his business, and believes the model will spread to other firms.

In many respects it already has. Health insurer Cigna employs 32,000 workers throughout the United States. Of that total, 4,400 do not have dedicated office space. These so-called “eWorkers” save Cigna roughly $10 million a year in leasing costs. “For every three eWorkers, we have only one dedicated work space. We're saving enough on real estate that the technology cost is a wash,” says Robert Hamilton, vice president of corporate real estate services at Cigna.

Cigna occupies 9.5 million sq. ft. of U.S. office space, 90% of which is leased. That 9.5 million figure isn't likely to grow either. Hamilton sees the eWorker program — which began in 1999 — as a way for Cigna to attract the best and brightest executives, too. He claims that voluntary turnover for Cigna's eWorkers is 50% less than for regular workers with dedicated offices.

“Our strategy is to eliminate inefficiency in real estate and human resources via technology,” says Hamilton. “We constantly look at our real estate expense rate versus the corporation's revenue.”

Offshore Issues

Aside from startling worker productivity and technological advances, there are new emerging forces putting downward pressure on demand in the U.S. office market. Forrester Research, a technology research firm based in Cambridge, Mass., projects that by 2017 roughly 3.3 million back-office jobs will move overseas. Based on this figure, one Ernst & Young consultant predicts that U.S. office demand will drop by approximately 50 million sq. ft. a year. Other projections peg that number as low as 10 million sq. ft., however.

“People are realizing that they just don't need all of that space. This is especially true when taking on a lease, as it is a long-term liability,” says Dale Anne Reiss, global director of Ernst & Young's real estate, hospitality and construction practice.

“Companies have learned how to be efficient, and we'll certainly see this trend accelerate,” she believes. Over the past few months, more than 31,000 white-collar jobs have been exported to India, Reiss says. Such a workforce is large enough to occupy roughly 7 million sq. ft. of office space, according to Reiss (assuming 220 sq. ft. per employee).

Owners Respond

So, in the face of increased worker productivity, technological advances and global competition that have combined to eat away at demand for U.S. office space, what's the solution for landlords and developers? Some are converting their office buildings into residential uses as a way to tap another line of demand. Others are setting the stage for a different type of office demand, one that seeks flexibility above all.

“Landlords will just have to realize that the 100,000 sq. ft. requirement is now 75,000 sq. ft. Tenants may want less space, but what they choose to lease will be better than what they had before,” says Jack Burns, a principal in the Boston office of tenant rep firm CRESA Partners.

If firms decrease the amount of space per worker, they may feel the need to give something back to them — otherwise workers may harbor some resentment. Consequently, firms reward their staff members by moving them into smaller, nicer space.

“If I can reduce my space and go to a Class-A building with better infrastructure, why not?” says Burns.

For landlords, this flight to quality suggests that class distinctions between properties will widen. Owners of Class-B and -C buildings with older infrastructure may start to feel adverse affects.

“Owners that do not keep up with the market for high-tech, quality space will get blown out of the water,” says Alan Deshulo, an advisor to CoreNet Global's New York-area chapter. He also believes that flexible space will be in demand by tenants in the future.

Texas-based office owner and developer Hines is designing many of its buildings with flexibility in mind. For example, it is using “raised-floor” technology in many new office properties. These floors create a 12- to 18-inch high chamber on the floor through which hot and cold air is pumped.

The result is a microclimate in each office space. Typically these HVAC systems are built into the walls of office buildings, rather than beneath the floor. “These systems are also 50% more efficient to move people around in, especially if a tenant has a lot of churn in their staffing,” says George Lancaster, vice president of corporate communications for Hines.

Moving people from office to office or even cubicle-to-cubicle is much easier with raised floors, says Lancaster. With the cabling and HVAC installed below the floor, tenants can custom wire their space much easier, too. The cost to install raised-floor systems in a new office building is more than a typical ceiling-duct system — roughly $1 per sq. ft. to $3 per sq. ft. during construction — but Lancaster believes that it's the wave of the future.

Unlike typical ceiling-duct systems, raised-floor ventilation pushes conditioned air through adjustable vents below each workspace. The end result is employees can control their microclimate.

Indeed, control is the operative word in today's business climate as corporate real estate execs seek to cut occupancy costs without disabling their businesses.

So, what's the bottom line? “Most people know that it will take a while to eat up all of this vacant office space,” says Bob Bach, national director of research at Grubb & Ellis. “And factors like outsourcing, technology and a possible labor shortage in the next few years means that it will be a much slower recovery.”

Editor Matt Valley contributed to this report.