As job losses mount and Corporate America downsizes its real estate needs, the amount of office sublease space is growing, a harbinger of rising vacancy and lower rents ahead.

From June 2007 through September of this year, tenants added 18.22 million sq. ft. of office space to the inventory available for sublease nationwide, a 25% increase, according to Grubb & Ellis. The increase in sublease inventory that began last year has been followed this year by an increase in space available for direct lease. Vacancy rates stood at 14.3% in the third quarter, up from 13% a year ago.

“It's definitely a predictive indicator of softening in the general leasing environment,” says Matthew Wright, client services manager in the Philadelphia office of Grubb & Ellis. “The confluence of increases in sublease space on the market and decreased tenant demand will certainly have an impact on softening of rental rates.”

For the U.S. office market, the second quarter of 2007 ended five years of positive absorption, the change in occupied space from one quarter to the next. Absorption was particularly robust from the second quarter of 2004 onward and ranged from 15 million sq. ft. to 25 million sq. ft. each quarter.

That trend reversed course when negative absorption totaled 3 million sq. ft. in the second quarter of this year, followed by a negative 2.1 million sq. ft. in the third quarter, according to Wright, who co-authored a national sublease report that Grubb & Ellis published in September. “We saw subleasing begin to tick up in the third quarter of 2007 and negative absorption picked up in the second quarter of 2008,” he says.

U.S. job losses year-to-date through September totaled about 760,000, according to the Labor Department. The slowing economy is driving companies to downsize, whether by subleasing their unwanted space or simply letting leases expire, says Alan Pontious, senior vice president and managing director of office and industrial properties at Marcus & Millichap. “There's no disputing that sublease space is growing as a result of the environment we're in,” he says.

Rent dip ahead

What do increasing subleases and negative absorption mean for most of the nation's office markets? Based on previous cycles, commercial real estate experts say declining rents are just around the corner. Boston-based Property & Portfolio Research (PPR) projects asking rents will begin to decline in the fourth quarter and bottom out around mid-2010.

Office landlords currently are asking for an average gross rental rate of $55.98 per sq. ft., but that rate is expected to fall to $48.99 before it begins to climb again in the second half of 2010. “What we're expecting is for rents to recede and basically wipe away most of the rent gains from 2007,” says Andy Joynt, a real estate economist at PPR's New York office.

So far, rents are holding firm. Even in Manhattan, where Class-A sublease offerings have doubled since the first of the year, asking rent is holding to a lofty $85.72 per sq. ft., according to Cushman & Wakefield. “Asking rents aren't moving yet,” affirms Ken McCarthy, Cushman & Wakefield's managing director of New York research. Cushman & Wakefield projects that asking rents will fall across the nation by the end of 2008, however.

Vacancy and downward pressure on rent are sure to increase in New York, which historically derives 14% of its jobs from financial services. That sector has seen more than 100,000 layoffs nationwide this year and is projected to lose as many as 50,000 more jobs by the end of 2008, according to outplacement consulting firm Challenger Gray & Christmas.

New York landlords are formulating plans to help their properties compete with a wave of new sublease offerings. Some are trying to sweeten the pot by offering built-out space that is ready for move-in, McCarthy says. “Tenants don't want to spend money on build-outs.”

Indirect pressure

A tenant is on the hook to pay rent through the end of a lease term regardless of whether the leased space is occupied, so landlords needn't fear losing rent when their tenant wants to bring in a subtenant. The real challenge to property owners is to maintain rental rates in a market where subleases offer tenants comparable space at below-market rates.

Tenants seeking subtenants will accept below-market rent because they simply want income to help pay their own rent on the master lease. Landlords, on the other hand, demand market rates in order to make a profit, explains Robert Sammons, director of research in the New York office of Colliers International.

Some landlords will have a hard time competing, particularly in markets like Manhattan where downsized financial services firms are hawking Class-A offices for sublease with excellent locations. “A lot of this space has a good bit of time left [on the master lease], and it's trophy space,” Sammons says.

A sublease tenant can expect to pay 25% to 40% less rent than the prevailing market rate, according to tenant representation specialist Marc Miller, an executive vice president at Winoker Realty Co. in New York. “That's about one-third off, and many of these spaces come furnished, some with phone systems,” he says.

Landlords can help maintain their property values by not allowing occupancy levels or rental rates to slip. But that job will grow tougher as subleasing gives tenants more bargaining power, says Pontious. “For about the next 24 months, a landlord today has got to be high on customer service and really prudent with operations,” he says.

Miller agrees. “If there's an electrical dispute or a tax dispute on a certain invoice, the landlord may want to swallow it,” Miller says. “The tide is turning slowly but surely to a tenant's market.”

A HARBINGER OF THINGS TO COME?

As the economy shows increasing signs of weakness and tenants downsize their space needs, office sublease space in several markets is on the rise as this sampling of key markets shows.

increase Office sublease space available (third-quarter 2008) Sublease space % (over past four quarters)
Austin 862,166 sq. ft. 248.2%
San Jose/Silicon Valley 1.3 million sq. ft. 73.9%
Manhattan 8.9 million sq. ft. 59.5%
Atlanta 5 million sq. ft. 37.3%
Chicago 6.4 million sq. ft. 10%

Source: Gribb & Ellis