In December, World Trade Center leaseholder Larry Silverstein claimed his first legal victory after 38 months of sparring with insurers over whether or not 9/11 was one or two occurrences. The jury's decision that the attacks were two events will give the 72-year-old developer as much as $4.6 billion of insurance money, enabling him to replace up to 5 million sq. ft. of speculative office space on the site.

The decision could also clear the way for five new office towers to be developed around Ground Zero in a larger plan that could cost as much as $9 billion. Before the verdict was announced, many observers doubted that Silverstein could build more than the iconic Freedom Tower (see rendering at left).

That bodes well for Silverstein, who has a 95-year term left on his $120 million-per-year lease from the Port Authority of New York and New Jersey. It also means that the stage is being set for a massive redevelopment on the 16-acre site that proponents say will reinvent lower Manhattan for the 21st century.

Yet this reinvention could derail the future of lower Manhattan's office market. Silverstein Properties has nearly finished the 1.7 million sq. ft. 7 World Trade Center tower at the north end of the site. It will open in 2006, but as of mid-December, none of the building's space was pre-leased.

Then there is the controversial Freedom Tower, expected to rise 1,776 feet above Ground Zero. It will bring another 2.6 million sq. ft. of space on line when it's completed in 2009. The Port Authority has committed to one-third, or nearly 800,000 sq. ft., of the space, but no one else has signed on so far. Five other office towers developed on the edge of Ground Zero could increase the potential new supply by 5 million sq. ft.

If these buildings are delivered over a six-year period, roughly 650,000 sq. ft. of new office space will be coming to market every year from 2006 to 2012. Some of that space may be pre-leased by then, but there is hardly any demand for it today. And that's unlikely to change for the foreseeable future, according to players in the downtown market.

“There's nothing that's going to stop the Freedom Tower from being built, and there's plenty more supply scheduled to hit this market too,” says Fred Trump, managing director at Manhattan real estate brokerage Newmark and nephew of Donald Trump. “That's not good news for this market, which still hasn't turned the corner.”

Make Way For Giants

Class A vacancy in Lower Manhattan fell from its post 9/11 high of 17% at the end of 2002 to slightly less than 14% in early November 2004, reports Cushman & Wakefield. But all it took was one building emptying out — when 554,832 sq. ft. was vacated at 100 Church Street — to drive the vacancy rate up to 15.9% by the end of the month. In comparison, midtown's Class A vacancy was 9.9% in November.

Downtown, which has been losing tenants to midtown, New Jersey, Brooklyn and the suburbs for decades, is compromised when it comes to transportation, convenience and space that's suitable for modern office needs. The addition of speculative space won't help. Lumped into this added supply is a 1.5 million sq. ft. tower that Goldman Sachs is building west of the Trade Center site.

Moving its employees to the new tower by 2009 will empty 2.7 million sq. ft. of space in five other buildings where they now work. (The five downtown leases expire between 2008 and 2021.) “This market just has no traction right now, and that doesn't look like it's going to suddenly change,” says Trump.

What will it take to rescue the lower Manhattan office market over the next few years? A growth spurt in the financial services industry would help. Even though downtown attracted its share of dot.coms in the 1990s boom as rents in other parts of the city soared, the area's fate is still inextricably linked to Wall Street.

Financial firms lease 26.6 million sq. ft. of office space in lower Manhattan, more than one-fourth of the 102 million sq. ft. inventory, according to CoStar Group. Other businesses occupy space in lower Manhattan, to be sure, but the finance sector represents the single-largest bloc of tenants.

At its peak, the occupancy rate for Class A space in lower Manhattan reached 98.3% in the fourth quarter of 2000, reports Cushman & Wakefield. That's the lowest vacancy the area saw since Cushman & Wakefield started tracking it back in 1987 (see chart, page 41). That changed abruptly after the 9/11 attacks. The dot.coms fled in force, and many other tenants followed them out. Class A office vacancy jumped from 3.7% at the end of September 2001 to 15.9% only one year later — a nearly 500% increase.

Fickle Finance

One explanation for why lower Manhattan's office market is so volatile centers on the shortsighted decisions made by many of its tenants. Investment bank Goldman Sachs is an excellent example. As its payrolls swelled in the late 1990s, the firm bought three development parcels across the river in Jersey City.

Goldman developed a $1.3 billion, 875-foot office tower — the tallest in New Jersey — on one parcel. In 2002, the firm announced plans to transfer its equity sales and trading operations from Manhattan to the new tower in 2003. But the staffers revolted and refused to make the move.

Goldman cut 13% of its workforce during the bear market. Unless the firm expands again, most of its Manhattan employees will fill the new 1.5 million sq. ft. tower in Battery Park City that Goldman plans to break ground on in 2005. Its decision annoyed city officials who questioned why the investment bank didn't plan to occupy space within 7 World Trade Center or the Freedom Tower. A Goldman spokesperson did not return calls for comment on the firm's real estate plans.

Goldman Sachs' enigmatic approach to real estate may be unusual among financial firms, but it does illustrate the risks of relying too heavily on Wall Street. “These finance firms are very good at making the gross revenues, but they have never been that great at running their own business,” says Lawrence Fiedler, a professor at New York University's Real Estate Institute. Despite Goldman's plans to remain in lower Manhattan, Fiedler believes that many Wall Street firms will continue to expand outside the city.

Glass Half Full

Yet market instability is a relative term. Andy Peretz, an executive director at Cushman & Wakefield, believes that the volatile downtown leasing cycle will help the market's ultimate recovery. “There's a real misunderstanding that there will be a glut downtown,” says Peretz.

“Everyone thought that downtown was over after 9/11, and they were wrong,” he says. “If you look at the cycles, you realize how hard it is to predict where the market will be in a matter of years. In 2000, every available space had multiple bids on it and vacancy was very tight.” Peretz believes that leasing demand will return to the market as these new towers are introduced to the market. He is counting on the three-year lag between the opening of 7 World Trade Center in early 2006 and the Freedom Tower in 2009 to help the market absorb the space.

Meanwhile, more residential conversions should also help trim the existing excess office supply. Roughly 3.4 million sq. ft. of downtown office space was converted to residential between the beginning of 2001 and the end of the third quarter of 2004. Cushman & Wakefield projects that 4 million sq. ft. of additional office space will be converted to residential units in the next few years.

Growth of the residential community in lower Manhattan and new amenities, such as a vastly improved transportation infrastructure and new retail, dining and performing arts venues around Ground Zero, should make the area more attractive in coming years. Meanwhile, the downtown office market has one huge advantage over midtown: price. Average downtown asking rents were around $32 per sq. ft. in November 2004, compared with an average of $52 per sq. ft. in midtown, according to Newmark.

“The thing that will lure tenants down from midtown is pricing,” says Peretz. “It's just so much cheaper to lease space downtown, and cost is a major consideration for tenants.”

NYU's Fiedler agrees. He also points out that the new towers in lower Manhattan could be the best deals in town. Since Silverstein is building with insurance proceeds, he can offer incredibly low rents. Fiedler is also convinced that the plans for a new transportation hub will make the area competitive with midtown once again. “The transportation in lower Manhattan will ultimately be on the level of Grand Central and Penn Station,” says Fiedler. “It will be the city's largest transportation hub.”