It's been a long convalescence for the office market. The sector is mending but slowly, with the national vacancy rate declining by 20 basis points in the first quarter to a still unhealthy 16%. The good news is that effective rents in the first quarter rose 0.6%. In a few markets, absorption is fairly healthy, and there's even spec office development, but these are islands in the stream.

According to Reis, which tracks 65 metro office markets nationwide, the drop of 20 basis points in the average vacancy rate marks the third consecutive quarterly decline. Among other first-quarter highlights: Demand for space was sufficient to spur positive absorption of 10.5 million sq. ft. across the board. Meanwhile, vacancies fell in 39 markets, and 44 markets posted positive absorption.

Effective rents rose to $20.23, the first quarterly increase in four years. Forty-four markets captured higher effective office rents, according to Reis.

“The trends are good, better than a year ago,” echoes Bob Chapman, senior executive vice president of Indianapolis-based Duke Realty, which ranks No. 9 on this year's Top 25 Office Owners survey with 29 million sq. ft. in its portfolio.

“Our occupancies are up 150 to 200 basis points over the last two years,” adds Chapman. “There's been some decent job growth in Atlanta, Dallas and some other markets, and space is being absorbed. But we have room to go.”

Burning off excess space

Development has tapered off considerably in many markets, which might allow excess inventory to burn off going forward. In northern New Jersey, for instance, developers completed 4.4 million sq. ft. of office space in 2002; the total for this year will be an estimated 300,000 sq. ft., according to brokerage Marcus & Millichap. In Dallas, developers completed 4.4 million sq. ft. in 2002 vs. a projected 600,000 sq. ft. in 2005

There are a handful of markets anticipating a significant uptick in leasing velocity due to a demand for certain kinds of office space. Washington, D.C. is a prime example. An estimated 21,000 office jobs will be created there this year — largely government-related, following increases of 13,000 office jobs in 2003 and 23,000 in 2004. Phoenix, another vigorous market, is likely to create 19,800 office jobs this year, with biotech especially strong.

In a few markets, such as Atlanta, there's actually spec office space development, typically smaller suburban properties. “We're going to develop 1 million sq. ft. of office across our system,” says Chapman of Duke Realty. “In Sugar Loaf near Atlanta, we have about 1 million sq. ft. there that's 98% leased, so we started a 100,000 sq. ft. spec building.” The building will open this summer 30% leased.

One anomalous major market is metro Chicago, where vacancies are still fairly high (18.9%) and yet office development continues briskly, with an estimated 3.2 million sq. ft. coming on line this year, double last year's total, according to Marcus & Millichap.

“In Chicago, you have construction teamed with a history of job deterioration,” notes Bob Underhill, managing director with Shorenstein Co., which ranks No. 23 on NREI's survey with 13.9 million sq. ft. in its portfolio. Shorenstein owns major office buildings in the Windy City as well as New York, San Francisco and Washington, D.C. Chicago is expected to add 26,000 office jobs this year, after adding 8,000 in 2004, but it's still not enough to replace the 45,000 lost between 2001 and 2003.

Buying Office in Bulk

While the office recovery remains uneven, investors show little sign of reining in their appetite for existing buildings, with real estate now firmly established as a popular investment option. Marcus & Millichap reports that the dollar volume of office purchases increased 28% from 2003 to 2004, to nearly $80 billion.

Moreover, cap rates are holding steady at low levels. Reis pegs the average U.S. cap rate for the office sector at 7.5%. CBD towers are trading at 100 basis points less than the average, while suburban properties sell at about 50 basis points higher.

“Build-and-hold is passé,” says Richard Gatto, executive vice president at Skokie, Ill.-based Alter Group, ranked No. 25 on this year's survey of office owners. Alter is a company long known for its build-and-hold strategy. “The model now stresses build and sell. In the history of U.S. real estate, this has got to be the best time to sell, because office cap rates have never been as low as they are now.”

TOP FIVE OFFICE SALES IN THE LAST 12 MONTHS
Property Name City Closing Price Sq. ft. Buyer
MetLife Building New York $1.72 billion 2.8 million Tishman Speyer Properties
One Madison New York $918 million 1.4 million SL Green Realty Corp.
Bank of America Center San Francisco $825 million 1.8 million IPC US REIT
International Place Boston $679 million 1.8 million Prudential RE Investors
Houston Center Houston $481.3 million 3 million JP Morgan Investment Mgmt.
Source: Real Capital Analytics