Here we are, more than halfway through the calendar year, and the nation's office markets continue to feel the adverse effects of a still-slowing economy. Transactions for office buildings have trailed off, leaving only the strongest REITs, pension advisers and foreign investors on the playing field.

Will this be a harder landing for the nation's office markets than most observers had predicted earlier in the year? Only time will tell, but for now, it's anything but a seller's market.

“The lack of velocity in office sales transactions over the last six months clearly is the most dominant trend, and we're seeing a fairly wide bid-ask spread between buyers and sellers,” said Stephen R. Quazzo, CEO and managing principal of Transwestern Investment Co., Chicago. “Buyers are counting less on growth in rental rates, and instead are seeking a higher current income component in their underwriting. Sellers' strong expectations on pricing, combined with the refinancing alternatives available to them, have made it difficult to close sale transactions.”

John Vander Zwaag, managing director of Chicago-based Cohen Financial, agrees. “Essentially, potential buyers are not prepared to pay the kinds of prices that sellers are taking to market. This phenomenon is most pronounced in the suburban office markets.”

That explains, in part, why many office investment markets have witnessed a slowdown in transaction volume.

Job losses, weakness in the capital markets and the dot-com/tech sector reversals of the past 12 months have resulted in significant repercussions on the national markets, perhaps to a greater degree than had been initially forecast, said Victoria Kahn, managing director at New York-based Clarion Partners.

More finite market data seems to bear this out, according to Lloyd Lynford, founder and president of Baltimore-based real estate investment research firm Reis Inc. “First-quarter market data released by Reis began to echo the downturn in the general economy, and our second-quarter data now confirms it,” Lynford said. “Demand for office space has substantially ebbed, and the 32.1 million sq. ft. of negative absorption recorded in the top 50 metropolitan markets is, at this point, an economic indicator of considerable probity. The national office vacancy rate has now reached 10%, the highest level since year-end 1997.”

Big players stack the deck

Given this background, the good news is that activity hasn't completely dried up. Instead, REITs, pension funds and foreign investors are still diving in, but mainly for higher-end trophy properties. But even then, leading observers can't agree on exactly which players are the real leaders.

Kevin Haggarty, executive managing director of New York-based Insignia/ESG Capital Advisors Group, identifies REITs as the dominant players for trophy property investments, particularly in the central business districts (CBDs), and for quality office product in markets like New York and New Jersey. “Pension funds are also buying CBD product through their advisers or in joint ventures with selected REITs and large family owners,” Haggarty said. “Also, pension funds and opportunity funds together [are buying] suburban and secondary city assets.”

Certainly, REITs also have faced their fair share of challenges. “REITs are hot as a stock investment because of yields, but they are still not able to issue new or secondary offerings, except for a very few of the top REITs,” Haggarty said. “Pension funds and other large investors, however, have been working with many of them on a joint-venture basis or private placement basis where the REIT brings in management expertise for a particular investment or series of investments.”

Jacques Gordon, international director at Chicago-based LaSalle Investment Management, a wholly owned subsidiary of Jones Lang LaSalle, cites pension funds as the dominant source of office investment capital. “Most are looking for fully leased core properties, although a few pension fund advisers will take leasing and repositioning risk on behalf of their clients,” Gordon said.

“REITs are very quiet as purchasers, as are most foreign buyers, although Germans will still go after trophy assets as they did recently with One Federal Street in Boston,” Gordon continued. “Another dominant source of investment capital includes 1031 tax-deferred exchange buyers who are looking to roll over their capital gains from astute purchases made in the last decade.”

But Tim Welch, managing director at New York-based Cushman & Wakefield, disagrees that pension funds are leading the investor charge these days. “Pension funds have reassessed their real estate portfolios and decided that they are too heavily allocated to office properties, so they are diversifying to increase their commitment to industrial and multifamily properties,” Welch said. “Pension funds and REITs own roughly 75% of institutional, quality commercial real estate nationally, so their move into some other asset categories is a very significant trend in the office markets.”

There are many good reasons to be investing in office properties right now: rental rates are good and there's relatively little new construction, according to Welch.

“The groups that traditionally define the market — pension funds and REITs — are not interested in buying,” Welch said. “If they have an opportunity to acquire office buildings at a very compelling return, they might be interested. You see this reflected in the growing spread between the bid and asking prices.”

So the question begs: Where are the life insurance companies that traditionally have been mainstays in this investment segment?

According to Welch, they have demutualized, transforming from mutual insurance companies owned by their policyholders into public companies owned by stockholders.

That puts a premium on their quarterly earnings. And owning equity real estate is complicated for an organization that reports earnings on a quarterly basis, because the depreciation expense attributable to real estate diminishes the return, Welch said. “With an insurance company, its income return is a major part of its investment return. So most life companies are not the major factors in equity real estate investment that they have been traditionally. The main players continue to be the advisers who represent pension funds and other institutional money.”

REITs are more active than they have been since early 1998, but they continue to face the same issues that they've faced for some time now. “They do not have as much access to capital as they did in 1996 through 1998, when they could go to the public markets and raise capital by selling stock,” Welch said.

According to Vander Zwaag, private money is still in circulation for the right office properties. “Most of the current investment activity is financed via entrepreneurial private capital rather than institutional money,” he said.

Leasing takes it on the chin

What just about everyone can agree on is that the “s” word, sublet, has been whispered in quiet corridors for some time now, as office markets across the country witness Corporate America's rapid-fire job cutbacks, and with it, less need for office space.

Large amounts of sublet space in major markets such as New York, Los Angeles and San Francisco are helping to slow rental rate growth and depress pricing, Kahn said. “This is not to say that you can now go shopping for bargains in New York City, but on a relative basis, there may be some truth to that as the amount of sublet space in New York has skyrocketed from about 2 million sq. ft. to close to 10 million sq. ft.,” Kahn said. “I believe San Francisco has seen close to double New York's rate of increase in available sublet space.”

Despite this increase in sublet space, most of the major markets are still in good health, Kahn believes. Washington, D.C., for example, has significant new construction under way, but Kahn estimates that vacancy will remain around 6% over the near term, while rental rate growth in the District, not including Northern Virginia, will continue to be a very strong 4% for the next two years. As a result, rental rate concessions are not increasing in D.C., particularly for smaller space.

New York, on the other hand, is experiencing softening rents and increasing landlord concessions, according to Kahn. But this does not mean that New York is a bargain. Vacancy in the Big Apple may increase to only 5.5% this year, making it arguably the strongest market in the country.

Lynford of Reis Inc. notes that nationwide, sublet space has become a major factor. While a complete census of sublet vacancies is not possible, second-quarter data indicates that approximately 22% to 28% of total national vacancy is attributable to sublet space, with significantly higher concentrations in markets such as San Francisco, San Jose, Seattle, Boston, Northern Virginia and Austin, Texas, according to Lynford.

“At the same time, it is important to observe that the root cause of [the second quarter's] negative absorption is not the tech-wreck typically associated with the recent flood of subletting. The problem is thornier than that simple assessment would suggest,” Lynford said. “Vacancy rates increased in 45 of the 50 markets, many of which have relatively minimal exposure to the technology sector. This trend illuminates the broadly based nature of, and sharp deterioration in, demand-side fundamentals.”

In fact, 12 U.S. office markets recorded at least 1 million sq. ft. of negative absorption (listed from most to least): San Francisco, Los Angeles, Boston, Dallas, Chicago, Northern Virginia, Manhattan, Detroit, San Jose, Atlanta, Denver and suburban Maryland, Lynford said.

Corporate America has embarked on a space-dumping spree, according to Gordon of LaSalle Investment Management. “Sublet space has been dumped on the market in record amounts, and this is where the bargains are for occupiers,” Gordon said. “Landlords are still trying to hold the line on direct lease space, but concessions are starting to creep back into the market.”

Rent concessions to lure tenants are an increasing possibility, agrees Barry Spizer, first vice president at the Chicago-based CCIM Institute. “In most cities, leasing levels are holding up pretty well, although we're starting to see some markets where a few months of free rent or other concessions are being offered,” Spizer said. Sublease opportunities are available in some markets due to corporate consolidations, especially within the high-tech and telecommunications industry and other Nasdaq companies, forcing the markets to be even more competitive than in the past.

“I've not heard of buildings going back to lenders or wholesale concessions, but more modest concessions of two to four months of free rent,” Spizer said. “Remember, we've had a tight office market for quite a long time, but where we had 97% or 95% absorption levels in some markets, that may be down to 90%. Leasing actually has leveled out rather than dropped off.”

Robert J. Hellman, senior managing director at New York-based Newmark & Co. Real Estate, said that the old adage of “the strong will survive” holds true for office investment markets.

“While many suburban markets throughout the country are beginning to soften due to the stock market downturn and subsequent price dislocation, 24/7 cities and major CBDs continue to be the focal points for many investors,” Hellman said. “Probably 90% of all investment action is currently taking place in cities like New York, Chicago, San Francisco, Washington, D.C., Los Angeles and Boston.”

Others, including J. Michael Dow, president of New York-based CRESA Partners, are striking a slightly more urgent tone. “The market is slipping quite rapidly. We are seeing landlords providing a significantly increased amount of concessions in an effort to attract tenants,” Dow said. “These concessions include free rent, work letters, lower rental rates and more flexible lease terms. Landlords are realizing that they need to give more of everything,” Dow said.

Delayed response

Much has been made of the technology industry's demise since the infamous stock market crash in April 2000. It has taken many months to seep down to the actual demand for office space, but it has happened.

The collapse of the technology sector has affected office building values in all markets, said Vander Zwaag, who emphasized that in most cities rent growth has ground to a halt, and that rents actually may soften over the short term. Certain tech-heavy markets, such as suburban Boston, Northern Virginia, Austin and San Francisco are taking significant hits, and can be expected to suffer a longer-lasting depression in rental rates, according to Vander Zwaag. “Moreover, numerous creditworthy tenants with new technology-related business lines signed leases for entire new buildings in these markets, but will never take occupancy, having redirected funding into their existing businesses. There is some uncertainty regarding the future of these properties, but ultimately they will contribute to increasing vacancy rates and downward rent trends,” he concluded.

While signs are surfacing that the slowdown is having an adverse effect on property values, the problem is spotty and most acute in Silicon Valley, Spizer said.

“It all depends who is on the lease. If a company like Dell, for example, has to vacate a building, the space more than likely will be sublet and the owner will get the rent that's due. But if the company vacating the space is a dot-com with little capitalization, the owner has no deep-pocket parent firm to go after,” Spizer said.

Dow of CRESA Partners said that problems in the tech sector should have provided sufficient warning signs. “The technology downfall was a major indicator that the economy, and subsequently, the property market, would decline,” he said. “The effect is determined by the weight of the tech sector within each city's economy. For instance, San Francisco is a huge mess, while New York [leasing] is down about 20%.”

Quazzo points to specific problem markets, but offers hope for a speedy recovery. While he acknowledges the Bay Area's dot-com woes and the softening of the telecom quarter in Northern Virginia, Quazzo said the good news is that the supply has not gotten dramatically out of hand, compared with the late 1980s. “We believe there will be a period of indigestion and, eventually, digestion of this excess space over the next 12 months because these properties are in high demographic areas, are very desirable places to live and have economies that are diversified enough to cause a rebound fairly quickly,” Quazzo said.

Signs are pointing in both positive and negative directions, said Hellman. “Despite — or because of — last year's incredible real estate boom, the faltering technology sector is creating a high degree of financial instability in the commercial real estate markets. Properties are not selling at the same cap rates they did a year ago, so investors are more cautious while sellers have pulled product off the market in response,” Hellman said. The good news, he added, is that certain so-called “Old Economy” companies are looking to burn off some pent-up demand for space that they couldn't afford when the dot-coms drove the market upward.

Where are the developers?

In the present environment, it's logical to conclude that office development is shutting down, but that's not an accurate assessment.

“Development will always be viable in those markets where vacancy is low and rental rates continue to exceed replacement cost,” noted Kahn of Clarion Partners. “For this reason, suburban office markets have seen a larger decrease in new construction activity than urban markets. Certainly, residential development is continuing at a very strong pace, and is likely to continue to do so over the near term as supply is unable to meet demand,” Kahn added.

But Quazzo says high-rise, multi-tenant office and downtown office sectors are less viable in the current economic environment than at any time during the past four years.

The most attractive and sought after niche, Quazzo said, is the 1- and 2-story office product. This product type can be brought on the market for $100 to $120 per sq. ft., has a high parking ratio and can offer rent levels that are attractive to tenants more focused on the bottom line than on pure image. “In select markets, there will continue to be opportunities in good locations to develop these 100,000 sq. ft. to 150,000 sq. ft. properties on a speculative basis,” Quazzo said.

Dow is far more skeptical. “Development isn't really a viable alternative in any market,” Dow said without hesitation. “Most economies are experiencing sufficient, even abundant, space being put back on the market. As a result, development is unnecessary. The space wouldn't lease up; it would be the most expensive space available. Development won't be a viable option again until 2002 or 2003, and only then with substantial preleasing.”

The economic slowdown has taken a lot of money out of the market and made investors and developers much more cautious, Hellman said. “There are still build-to-suit development opportunities available, as well as multi-tenant projects in some key markets throughout the country, but substantial pre-leasing is a requirement. Interestingly, some landlords in New York City are currently developing new product for telecom/data center use,” Hellman said.

Innovative leasing programs

In an effort to lease up the glut of sublet space, owners are turning to a variety of unique leasing programs.

“All the ‘smart building’ features like high-speed Internet and broadband connections will be in demand as tenants become cognizant of these features,” said Spizer of the CCIM Institute. “All companies are becoming more dependent on technology.”

“I've also seen a lot of offices designed with leisure spaces or relaxation areas where employees can mingle and have a relaxing time. These types of amenities help lease up a building. Developers can no longer offer a plain, square box,” Spizer declared.

Transwestern has received favorable responses from tenants who have opted for rent-ready suites measuring between 1,000 sq. ft. and 2,000 sq. ft. “We've found this approach to be extremely worthwhile in a number of markets because potential tenants can see, touch and feel a ready-made space configuration,” said Quazzo. “Broker incentives and being responsive don't hurt either.”

And ironically, technology itself may prove to be a godsend for beleaguered office markets by helping to connect tenants and landlords.

“The advent of online listing services has helped both tenants and landlords find each other,” Gordon said. “These online services have become the brokers' best tool for operating efficiently, in contrast to the perceived threat that they posed to the brokerage industry a few years ago.”

Lynford of Reis said the high rate of negative absorption posted in the second quarter is somewhat of an anomaly. “But,” said Lynford, “the second quarter data very clearly indicates that the probability of a harder landing in the U.S. office market has undeniably increased.”

Ben Johnson is an Atlanta-based writer.