Roughly 25% of the nation’s leased office space is set to expire in 2011 or 2012 and tenants are moving into the driver’s seat in negotiating new terms with landlords already pressured by a glut of vacant space. That’s the conclusion of a new report by Encino, Calif.-based real estate services firm Marcus & Millichap.

As leases come due, many firms will move to smaller blocks of space than they currently occupy. The downsizing comes against the backdrop of an economic recovery that is expected to make “slow, choppy progress” through the remainder of 2010 and during the early months of 2011, according to the report.

Researchers warn that risks such an another slide in the housing market and eroding consumer confidence persist, however they conclude that the chance of a double-dip recession remains unlikely. The consumer sector accounts for 70% of U.S. gross domestic product (GDP), but it will remain hampered by tight credit and high unemployment over the next several quarters, according to the outlook.

The nation’s office vacancy rate rose 10 basis points to 17.4% in the second quarter, the 11th consecutive period in which vacancy rates increased, according to Marcus & Millichap. The vacancy rate has spiked nearly 500 basis points from the cyclical low point, the highest rate since 1993.

Law firms shrink demand
The country’s biggest office tenants continued to contract in the second quarter. Law firms, which account for more than 9% of all occupied space and the greatest square footage per employee, are still laying off workers. More than 77,000 legal jobs have been cut since 2007 , a 7% decline from the peak. The losses are expected to persist through the end of 2010.

Across the country, at more than 400 sq. ft. per employee, the decrease in legal employment represents a drop in space demand of more than 30 million sq. ft. but the losses are not limited to law firms. Employment in the financial sector is projected to contract for the fourth consecutive year in 2010, weighing on space demand well into the economic recovery.

In major cities, a number of trophy properties could be affected by the downsizing. In addition to being large users of office space, legal and financial firms often occupy some of the most expensive Class-A space. As these users vacate space, managers will encounter challenges achieving current rental rates when new tenants move in, according to Marcus & Millichap.

As the vacancy rate climbed, negative net absorption totaled 1.4 million sq. ft. in the second quarter. The figure actually represents an improvement in the pace of contraction of tenant demand. Since the recession began, tenants have returned an average of 14.6 million sq. ft. of office space per quarter.

Big cities shine
Altogether, the major markets of New York City, Washington, D.C., Chicago and Houston account for more than 25% of the nation’s office supply. Despite mixed employment performance in these areas, each recorded positive absorption and modest vacancy improvements in the second quarter, the researchers report. Secondary and tertiary markets didn’t fare as well, however.

In cities where new tenants are securing space, they are gravitating to central business districts.

Positive net absorption in the central business districts totaled 2.6 million sq. ft. in the second quarter, while tenant demand remained soft in the suburbs.

Deals pick up
Sales velocity improved by 5% in the second quarter compared with the first quarter of 2010, and transaction activity in the first quarter was greater than the pace set during the same period last year. Although institutions and REITs were more active than during the same period last year, the higher deal volume is likely a bounce off the bottom rather than a sustainable strengthening of demand, the authors report.

Low interest rates and uncertainty surrounding future tax rates will likely fuel sales velocity in the second half, but, ultimately, net operating income gains will be needed to deepen the pool of active buyers.

The greatest increases of investment activity occurred in primary markets where occupancy has shown the most improvement.