By the beginning of 2004, occupancy had dipped to 40% at 601 California Street, a 250,000 sq. ft. office building in the heart of downtown San Francisco. The bad news started two years earlier when the biggest tenant, investment bank Robertson Stephens, vacated 40% of the building.

Once a key player in Silicon Valley, Robertson Stephens shut down its operations as technology stocks languished. Other tenants faced similar hard times. But in recent months, financial and technology firms have been taking space in the California Street property owned by Hines, the big Houston developer. Now the building is 60% occupied. “We are seeing signs of real recovery in San Francisco,” says Daniel MacEachron, senior vice president of Hines.

With employment growing, office markets are slowly improving around the country. The national vacancy rate for all classes of space in the third quarter of 2004 registered 14.1%, down from 14.6% a year earlier, according to Bethesda, Md.-based research firm CoStar Group. Net absorption for the quarter was 30 million sq. ft., up from 13.8 million sq. ft. in the third quarter of 2003, CoStar reports.

Office developers are confident that real estate fundamentals will continue to improve in the next year. They note that there has been a decline in the amount of listings of sublease space. Companies that had held empty space in reserve are now filling it with new employees.

While demand for space is showing signs of life, the development pipeline nationally has slowed considerably. In Washington, D.C., 493,000 sq. ft. of new office construction started in the third quarter, compared with an average of 1.64 million sq. ft. started in the previous 11 quarters, according to CoStar.

Property & Portfolio Research projects that 61.9 million sq. ft. of office space will be completed in 2004, down from 76.2 million in 2003 and 121.3 million in 2002. That slower pace of construction combined with increasing demand is healthy for the industry. “In the next year, we should see vacancy rates improve around the country and absorption picking up,” says Tom Roberts, CEO of Opus West, an officer owner in Phoenix.

Markets are particularly strong in Southern California, New York and Washington, D.C. Another bright spot is Scottsdale, Ariz. Thanks to its beautiful scenery and low cost of living, the area is attracting jobs.

The Alter Group, an office owner and developer in Skokie, Ill., is developing 188 acres near two interchanges on Arizona Route 101. The company is building two properties with 260,000 sq. ft. of office space on speculation. In addition, Alter is developing a 140,000 sq. ft. office that is pre-leased. “Scottsdale is one of the few areas in the country that escaped the downturn of the past few years,” says Richard Gatto, executive vice president of the Alter Group.

In markets that suffered the most during the downturn, some bottom fishers have appeared. CarrAmerica, an office owner based in Washington, D.C., recently bought 331,000 sq. ft. of office space in North San Jose, deep in Silicon Valley. The buildings are only 42% leased. “A year ago we wouldn't have taken on the risk of these vacancies,” says Philip L. Hawkins, president of CarrAmerica. “But now Silicon Valley has stabilized. Brokers and tenants are much more optimistic.”

Executive Insights

Name: Daniel MacEachron

Title: Senior vice president

Company: Hines

Headquarters: Houston

Biggest Surprise of 2004:

“Capitalization rates dropped by 150 basis points on prime properties. That is a huge decline. It occurred because the fundamentals are improving, and there is widespread optimism that the markets will continue recovering.”

Prediction for 2005:

“There should be steady improvement in most markets. A few markets — including San Francisco — have the potential for big gains.”