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Office market fundamentals to spur new growth and development

The downsizing of corporate America that has plagued the office market in recent years by dumping millions of sq. ft. of empty buildings and below-market-rent sublet space has ended. A stronger economy has boosted new business growth, particularly with small and mid-sized companies that are looking to expand.

This combination of factors is bringing supply and demand fundamentals in the office sector to more of an equilibrium and is driving its rapid recovery. The changes have dwindled vacancy rates and driven rents in some markets to the point they are experiencing speculative development. Other markets, however, further down the recovery curve, are still searching for the right balance of supply and demand.

"At the national level, the supply and demand fundamentals are improving more rapidly than we had anticipated," says Jacques Gordon, director of research with Chicago-based LaSalle Partners Ltd. "In 1990 and 91, some analysts were predicting no new development until well after the year 2000."

But new speculative projects are currently underway in the Columbus, Ohio and Raleigh/Durham, N.C., markets. Larger markets such as Atlanta, Boston and Denver, which have experienced significant drops in vacancy rate (to single digits in some sub-markets) are not expected to be far behind, with several projects already in the planning stages. On the other hand, other markets, such as the central business districts of Houston, Los Angeles and Hartford, Conn. for example, will probably not be ready for new development for at least three to five years, says Gordon.

Regardless of the health of the market, the past is going to affect financing. "I think there will be a supply of capital in the marketplace," says David Latvaaho, national director of leasing with Chicago-based Heitman Properties Ltd. "But it is going to be difficult for the next couple of years because the rules have changed. A lot more preleasing will be required and probably equity on the part of the developer and a realistic proforma relative to rental rates."

"There is a very rapid recovery in capital interest in buying and financing office properties," says Gordon, "although it is much more rapid for suburban properties now than downtowns."

The stoppage in new office construction the last five years has been the major factor in taming the oversupply problem. However, the elimination of corporate downsizing (now thought to be complete) and sublet space (now substantially absorbed), which were negating leasing gains, has had a major impact on lowering vacancy rates, particularly now that demand has increased.

"What happened around the country is that even though we have had positive absorption in all of our markets around the country, the sublet space and space put back on the market due to downsizing was suppressing rents," says Latvaaho. "Now if you look at most of the markets, that sub-let space is gone."

The recent explosion in the growth of small entrepreneurial firms has been another answer to the vacancy question. "You have to look at both sides of the equation," explains Tom Bakke, senior vice president of marketing and leasing, with Chicago-based Equity Office Properties Inc. "The supply side is only one aspect. Many people thought because there was no new supply the space would fill up, but that is not necessarily so. The key is having, not only limited supply, but also, increasing demand."

Latvaaho says markets where this is the case could see rent spikes as high as 25% in the next two years.

"Demand is everything that is how much occupied space there will be," says David Birch, president and founder of Cognetics Inc., a Cambridge, Mass.-based producer of software that helps investors anticipate demand for office and industrial space.

But lower vacancy rates haven't translated into higher rents in all markets. "Rental markets move differently than the supply-demand fundamentals, and oversupply of space is a major reason." says Gordon. "While absorption may drop vacancy five percentage points, which is a tremendous improvement, if that drop is from 20% to 15%, rents may not be affected. My point is that 15% is still an oversupply and will not produce rapid rent increases. You are not going to see rents ratcheting up quickly until that 15% vacancy in the market moves to 10%."

But overall, vacancy figures alone can be deceiving, not only from a market to market perspective, but across product types as well.

"Looking at all the available space in downtown Chicago, it is about 18% vacant," explains Bakke, "but if you segment into Class-A product, the vacancy there is only about 13%. So all of a sudden, markets that may have looked very weak from a pure numbers analysis may be much stronger in certain segments."

The same can be true regarding obsolete space in a market. "In many of the older CBDs (central business districts) like Chicago and New York, there is a lot of office space that is never going to compete again because to convert the space to a competing level would be more costly than it is worth," says Bakke. "So in relation to the competitive product in the market, the vacancy rate in these CBDs is actually not as high."

Latvaaho agrees. "A lot of the space is functionally obsolete and should not be put into the equation. There is some Class-B and Class-C space that will never be occupied for office use again because the space will not fit tenant needs."

But the perception persists that the CBDs are in worse shape than the suburban markets, and this is undoubtedly true in markets such as Los Angeles and Dallas, where a report by GVA Worldwide, an international alliance of 40 real estate firms, stated that, of major CBD markets worldwide, these two were the only markets with Class-A vacancy topping 20%.

A recent report from Cushman & Wakefield for the first quarter of 1995 showed some hope for America's CBDs in the long term. "A reflection of the strength of the downtowns was the fact that 21 of 31 markets had vacancy rate declines, while five remained unchanged," says Arthur J. Mirante III, president and CEO of Cushman & Wakefield.

No question they still have a road ahead of them, since suburban markets continue to look stronger overall. Nationally, Cushman & Wakefield reported CBD vacancy at the end of the first quarter at 16.9% compared with 16.6% for suburban markets.

"The suburbs have done better than the downtowns in most areas, but the national occupancy levels for the two sectors is about the same," says Latvaaho. But some feel the statistical chasm between suburban and CBD space may just be forming.

"You have to remember one key thing, and that is the suburban markets got much uglier than the downtown markets did," says Bakke. "The suburbs' vacancy got to 22% at one point while the downtown rate only got to about 19, so relatively speaking the suburbs have done much better."

"The point is when corporations and financial institutions have a choice, they are avoiding the less dynamic downtowns that lack residential and entertainment," says Gordon. "So it is not so much of a supply problem as it is a demand problem."

Says Birch, "In the suburbs, it is cheaper to do business (lower taxes), it is more attractive, there is less crime, better schools, less commuting, free parking, the mall, everything people want is there. And the political situation in the inner city is usually a nightmare."

The better performing CBDs are usually the "24-hour communities," Bakke explains. "These CBDs have a good mass transit system, entertainment to draw visitors at night and residential areas. CBDs that don't have these are probably not going to be good office markets."

Many cities are trying to attract business back to their CBDs through a variety of means.

"Downtown Dallas is in what has been deemed an enterprise zone by the city," says Chris Hipps, director of leasing with Dallas-based Prentiss Properties Management & Leasing. "This program offers tax abatements and money for job training of employees to large tenants that locate in the zone."

Also, there is the Dallas Improvement District, a self-imposed tax district for landlords in the downtown. "They tax themselves an additional increment and that money goes toward improving the area, through trash pickup and beautification efforts," says Hipps.

But Bakke is skeptical of the programs' success. "Dallas is trying hard to improve, but I think it is going to be tough because they do not have mass transit or residential downtown," he says.

Some reasons for the strength or weakness of markets go beyond geography, but others such as quality of life, population and job growth can be tracked region to region. The following is a look at these regions, the Northeast, Southeast, Midwest, Southwest, Rocky Mountain and West Coast, and some of the reasons behind each area's performance.

Northeast

In general the office market in the Northeast is recovering slowly, but may never be what it once was, the primary reason being loss of population. People are moving to other areas of the country where jobs are more plentiful. Cognetics Inc. estimates that less than 200,000 jobs will be created in the New England market between 1994 and 2004, while more than 1.3 million new jobs are predicted for the South Atlantic region.

"Massachusetts has lost more than 300,000 in population since 1980," says Birch. "And the same thing is happening in New York, New Jersey, Connecticut and Rhode Island. Millions of people are bailing out of these areas and heading for the Southeast and out west."

Many Northeast markets are dominated by a particular industry and thus are subject to its strength. The Hartford, Conn. market is dominated by the stagnant insurance industry which has been downsizing. "For every company that grows in Hartford, two others shrink," says Bakke. Cushman & Wakefield report that Hartford's CBD vacancy rate was 25.6% for the first quarter of the year. The suburban rate was only slightly lower at 24.2%. Two other Connecticut markets, New Haven and Bridgeport, had two of the highest vacancy rates in the country in 1994.

However, the Stamford market, historically one of the worst in the country, is seeing some improvements due to companies making the move from New York. Its Class-A space vacancy has dropped to 13%. "These executives are saying, 'why pay $30 in New York when I can move closer to home in Stamford and pay $20?'" says Bakke.

Philadelphia also has suffered through company downsizing and moves. The CBD vacancy rate is 18%, while the suburbs sit 16.4% empty. "Philadelphia has lost major users and they have large blocks of contiguous space in the city."

The best news in the Northeast is Boston. Dominated by the booming financial services industry that is rapidly expanding, the city's CBD is getting tight. "In the better product there is hardly anything," says Bakke. Class-A vacancy in the city's CBD at the end of 1994 hovered at 10%, according to GVA Worldwide.

Overall, Cushman & Wakefield reports that both CBD and suburban vacancies in Boston for the first quarter were around 11%. The suburbs were being driven by bio-medical and other high-tech firms. "That comes from all of the MIT (Massachusetts Institute of Technology) graduates going out and starting their own firms," says Bakke.

The Washington, D.C., market's traditionally strong office sector continues. The CBD's vacancy rate is just above 10% and all but one of the suburban submarkets have vacancies below 10%, including the Crystal City submarket, virtually fully occupied with a 2.1% vacancy rate. The market absorbed more than 750,000 sq. ft. in 1994.

"The Tyson's Corner market is coming back, and there is growth on the periphery of the city," says Latvaaho. "They are building buildings there, so that speaks well of the whole market."

Overall, the active leasing pace appears to be continuing. According to The Carey Winston Market Review Spring 1995 report, the D.C. area saw positive net absorption of 378,000 sq. ft. in first quarter 1995.

Not to be forgotten is New York City. The country's largest commercial office market racked up nearly 3.2 million sq. ft. in deals during Julien J. Studley's latest March/April reporting period. That's up 25% from the January/February period, but off by 41% from a year ago.

"Despite this slowdown from last year's activity, the general mood in the market is upbeat," notes Maurice Solomon, vice chairman and manager of Studley's midtown office.

Southeast

The Southeast, lead by Atlanta's status as the nation's number one creator of jobs and enhanced by the rapid growth in the burgeoning markets of Charlotte, N.C., and Orlando, Fla., remains one of the top two office market regions (along with the Mountain States) in the country.

Not only does Cognetics Inc. research estimate Atlanta to generate more that 161,000 office jobs between 1994 and 2004, but three other Southeast markets, Miami-Fort lauderdale, Tampa-St. Petersburg and Orlando, are in the top 10.

Quality of life is a major factor in attracting companies to the Southeast. "There is a great migration to the Southeast," says Latvaaho. "The standard of living and the cost of living are both very good."

"It is a more modern economy," agrees Birch. "Relatively speaking, the Southeastern cities are all brand new and inexpensive places to live."

Another reason for the region's rapidly expanding job growth is education.

"The South is developing some great research universities," says Birch. "MIT just lost a high-energy magnetism research center, which moved to Florida State in Tallahassee. Duke is a great university, and the University of North Carolina at Charlotte is becoming a very good school. These schools spawn a lot of new companies because that is where the brain power is."

The vast majority of the Southeast's growth is limited to a few major markets.

"Atlanta is in a different league compared with the rest of the Southeast, in terms of health of the marketplace," says William Mitchell, chairman of Atlanta-based CARTER. "Rental rates are moving up into the double digits to a level where new construction really makes sense. During 1995 we will see close to 1 million sq. ft. start construction in the Atlanta market."

"The suburbs of Atlanta are very healthy, and I think the Olympics has spawned a lot of optimism," says Bakke. "Rents in some of our Atlanta properties approach replacement costs right now. The market is on the verge of new construction."

The Atlanta CBD has suffered from overbuilding and many of the other problems associated with downtowns, but it has a few bright spots. Mitchell says The Southern Co. has decided to move its corporate headquarters back to downtown before the end of the year. In addition, he expects good absorption in the CBD this year and next due to the Olympics.

Charlotte's position as a growing banking center has tightened its downtown office market, through the expansion of both NationsBank and First Union. "Their acquisitions of other banks have created some streamlining in those assets but has required more management in Charlotte.

"Charlotte is behind Atlanta as far as the recovery goes, but it is a very strong market as well," says Gordon.

Across the state, the Raleigh-Durham market is being driven by high-tech industry and The Research Triangle. Although not as deep a market, Cognetics ranks Raleigh-Durham in the top 20 markets for office employment growth in the next 10 years.

Florida is a state of emerging and recovering markets. Orlando and Tampa are becoming strong business centers. "Orlando is becoming the business capital of Florida," says Bakke. "It is centralized to a certain extent, Tampa and Jacksonville are both only 90-minutes away and the state's banks tend to be centered there."

GVA Worldwide reports Orlando's overall vacancy rate at 12.2% and 11.4% downtown, but rents have not yet moved enough to justify new construction.

Midwest

While demand has continued to be relatively strong in many Midwestern markets, Gordon says overbuilding came to the region later than it did to other areas. As a result many Midwestern cities such as Chicago and Cleveland are still working off an oversupply of space.

But Chicago absorbed more than 2 million sq. ft. during the second half of 1994, according to ONCOR[center dot]International statistics. "And has some very tight markets in the northwest part of the city," says Gordon.

However, Cleveland's absorption during the third and fourth quarters was less dynamic, at only 452,000 sq. ft. "Cleve-land is still in difficult straits because they were the last to stop building," says Latvaaho. But he adds that most Midwestern markets, such as Milwaukee, Des Moines and Cincinnati, are doing reasonably well and recovering, albeit slowly.

Detroit has had good job growth, but the office market, particularly downtown, is lagging. "Their downtown is just dysfunctional," says Gordon.

But all is not mediocre. The region also includes the strongest office market in the country in Columbus, Ohio. Although small (11.8 million sq. ft.) compared to some other Midwestern office markets, its vacancy rates are the lowest in the country. GVA Worldwide reports the overall vacancy rate at 4.9%, half what it was a year ago. And in the CBD only 2.6% of Class-A space and 5.4% of Class-B space is vacant.

Last year, as such numbers would lead you to expect, absorption was positive in every submarket. And net rents have increased 27.5% in the last two years.

"Columbus moved away from manufacturing and into service-based industries faster than other cities in the midwest," explains Gordon. "And it has much younger demographics than either of the state's heavyweight markets, Cleve-land and Cincinnati, something corporate America favors.

"It is the capital of Ohio and has the university [Ohio State]," says Bakke. "And it is one of the first markets where speculative development has returned."

The rising rents are spurring build-to-suit offers from local developers. "We are having trouble keeping tenants in our buildings there because developers are offering to build them buildings and still offer them a lower rate," Bakke adds.

Minneapolis/St. Paul's economy has strong underpinnings "because there are a lot of Fortune 500 companies there," says Latvaaho. "The market has a low unemployment rate, a highly-educated workforce, all of the things companies are looking for.

"The only unfortunate thing is that the twin cities have an anti-business climate with a lot of taxes," he adds.

But this doesn't appear to have hurt the market's recovery. GVA Worldwide reports that despite a 21.2% vacancy rate in 1991, the market absorbed 4.4 million sq. ft. during the last two years, lowering the vacancy rate to just 11.1%. In downtown Minneapolis the vacancy rate is just 10.4%.

"Minneapolis always makes the top 10 list of best cities to do business in," says Gordon.

Although the tax rate is high, the CBD is helped by the area's unique regional government system that shares the tax burden with the suburbs.

Indianapolis has not seen as dramatic a fall in vacancy rates, but it has displayed a robust economy that has lowered vacancy from 20% to 15%, says Gordon. "The growth comes from companies moving there to get away from urban areas such as Chicago."

"People are saying, 'Why do I need to be in Chicago when I can get the same or better distribution in Indianapolis?'" says Bakke. He points out that both United Parcel Service and United Airlines have developed large warehouse projects in the market, primarily due to its status as a good distribution hub because it has a good highway system and central location.

Southwest

The Southwest was one of the first office markets affected by the recession in the 1980s, due to massive overbuilding and the turmoil in the oil industry. The major markets, both Houston and Dallas, are still suffering the consequences -- at least downtown. But midsized markets, such as Austin and San Antonio, have come back strong.

"The Texas market has not really come back the way many people expected," says Latvaaho. "In Houston, the growth has essentially stopped. It is a very flat market." ONCOR * International reported a 24.7% vacancy rate for the market at the end of 1994.

Downtown Dallas has an overall vacancy rate of more than 21% to begin 1995, including a 34.9% vacancy in the CBD, according to ONCOR. But the city's northern suburbs have been a bright spot.

"The near north Dallas submarkets of Preston Center, Las Colinas and Turtle Creek/Oaklawn have for the most part Class-A product, and as the downtown situation got more and more discouraging in the late 1980s, these suburbs began to fill up," says Hipps. "That space has become harder and harder to find."

Jay Lucas, president of the Commerical Investment Real Estate Institute (CIREI), says tenants better do their deals now. "It will only get more difficult and more expensive the longer they wait. The Dallas office market is truly improving at an exponential rate and by yearend 1995, developers will start talking about new office buildings with new space rates $3 to $5 per square foot higher than rates today."

Being smaller markets, both Austin and San Antonio are subject to quick shifts in the market, and both were helped by unique factors.

"Austin is the state capital and also benefited from the high-tech demand and labor force created by the University of Texas," says Bakke. "San Antonio has been helped by the North American Free Trade Agreement (NAFTA), as companies wanting to do business with Mexico are locating there."

Austin, which sported a vacancy rate percentage in the high-30s, is now down to just 10%. "It was an example of some of the worst excesses in overbuilding," says Gordon. "But now it is an example of how quickly things can change."

Rocky Mountain States

When it comes to quality of life, no area offers more than the Rocky Mountain states. Its clean air, wide open spaces, relatively low crime rate and low cost of living are drawing large numbers of people to the entire region. Established companies are following to tap the labor force, while entrepreneurial companies are sprouting from that growth.

In general, it is the lower cost of doing business, a highly educated labor force and affordable housing," explains Gordon. "This all looks real good to workers and business owners struggling to make a go of it in California."

From Boise, Idaho, to Phoenix, the office markets are healthy and getting much stronger as a result of more and more high-tech companies discovering the markets.

"They are all benefiting from an exodus from California," says Bakke, adding that technology has made corporate moves to these more isolated markets feasible. "Communication connections with stock markets and computer networks are allowing companies to operate in more remote locations than ever before," he says.

One prime example is Boise. Currently the city is associated more with high peaks than high-tech, but that may be changing. "Boise is getting a lot of population and job growth, and many smaller knowledge-based businesses that have gravitated to the area are the reason," says Gordon. "The founders of the software companies that drove the silicon valley in the Bay Area appreciate life in Boise. There are some things not to like about the Bay Area these days, and Boise offers a very attractive environment."

Other Rocky Mountain markets are reaping similar gains; Salt Lake City, Las Vegas, Phoenix and to a lesser extent Denver have all benefited, although the forces behind each one's recovery differ.

Salt Lake City's recovery is being driven by the Silicon Valley software companies. "It is about 8% vacant right now," says Bakke, "but again, as a smaller market it is susceptible to quick recoveries and quick down cycles."

Although Las Vegas may not seem like an office environment, its tremendous growth and that of its blue-collar suburb, Henderson, Nev., has generated a substantial demand for office space," advises Gordon.

The Phoenix market was spurred by the absorption of 1.7 million sq. ft. in 1993-94, which played the largest role in dropping the city's vacancy rate from 26.5% in 1991 to 12.9% at the end of 1994. As with most of the smaller markets in the region, the downtown vacancies are relatively high, but the limited amount of CBD space doesn't have a major impact on the market's over-all rate. "Because they are newer cities, they tend to not have as much of a focused downtown," says Gordon.

"These are wide-open economies with good airports and without the congestion of more developed areas," adds Birch.

The relative strength of these markets can be seen in the Regional Economic Growth Index, which is basically an indicator of office demand, ranking 110 U.S. office markets and compiled by LaSalle Partners. The company's research ranked Phoenix third, Las Vegas fourth, Salt Lake City eighth, Boise ninth and Denver 12th.

Denver is a much larger economy than the other markets in the region, "and it has its own story, but its growth is quite strong as well," stresses Gordon.

Bakke says the telecommunications industry is driving Denver's most recent wave of growth, as MCI and cable companies have absorbed a large amount of space.

"Denver still has a substantial overhang downtown, but what excites people about the market is how it has improved so dramatically," says Gordon, adding that Denver's suburban vacancy rate dropped from 15.7% to 10.5% in one year.

Latvaaho agrees. "Denver's strength has surprised people. They were giving away space six or seven years ago."

While the region is not thought of as a major producer, its contribution to the national economy has grown significantly.

"The knock against the Mountain States has always been the impression that it does not include many jobs or opportunities and that the depth of the economy just isn't there," says Gordon. "But the Mountain States are as large as New England, in terms of their contribution to the national economy."

West Coast

The West Coast office market appears to be difficult to gauge and maybe stronger than it appears at first glance. Although the high-profile Los Angeles CBD is one of the worst office markets in the country, the city's suburban submarkets and other markets across the region are doing well.

"Los Angeles was the last major market to hit rock bottom in the real estate industry," says Bakke. "Downtown is still struggling but Glendale, Beverly Hills, Westwood and others are turning around."

Bakke says its Pacific Rim connections and the results of NAFTA have been strong for Los Angeles and are playing a large part in the recovery of some submarkets.

Birch agrees. "There is a large Asian influence, particularly in Orange County," he says. "The population of Irvine is about 17% Asian as a lot of Japanese and Korean companies have headquarters there. There is a large Mexican influence as well. So they have the best of all worlds; they have Latin America, Asia and the United States, and I don't think it is going to go away."

GVA Worldwide reports that leasing activity on the Westside has increased to its highest level in four years, lowering the vacancy rate to just 15%, down from 19.4% two years ago. Despite a slight decline in CBD vacancy, below 19%, during the first half of 1994. The rate has now gone back up to 22%.

To the north in San Francisco, its 24-hour downtown has the CBD vacancy rate at 11.4%, according to Cushman & Wakefield figures, while the suburbs east of the city have a rate of less than 10%. Vacancy on the peninsula is down to just 6%.

"Palo Alto is as strong as any market anywhere," says Bakke. "It is driven by Stanford and the research industry in the area."

South of Los Angeles in San Diego, the suburbs have done well, even though the impact of NAFTA has been minimal to this point. "But it should pick up in the future," advises Bakke.

He says the vacancy rate is around 17%, but has dropped 2% in the past year. "We are in the Golden Triangle, an area in the suburb of La Hoya, and vacancy is down to 11%," he says. Defense, engineering and bio-tech are the industries driving the San Diego market.

In the Pacific Northwest, Portland's office market is strong with both CBD and suburban vacancy rates below 10% according to Cushman & Wakefield. Seattle also sports a low CBD vacancy of 9.5%, although its suburban number is in the mid-20s.

"Portland and Seattle are good markets and are probably right for new building because I think they are going to see a spike in rents," says Latvaaho.

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