Despite falling vacancies and limited new construction, the national office market is experiencing only a modest uptick in rents. Landlords in tight markets like Washington, D.C. and New York City are two notable exceptions to the rule.

Data from New York-based Reis shows that average effective rents nationally increased by just 0.9% between mid-year and the end of September when they hit $20.45 per sq. ft. And rents are still well below the $27.35 per sq. ft. peak achieved in late 2001.

“The office recovery is moving slow and steady, but it doesn't look like 2006 will be the year that most office owners can significantly boost rents,” says Bob Bach, national director of market research at real estate services firm Grubb & Ellis.

How can that be? One explanation behind the slow office recovery is the rise in worker productivity since the recession. Also, corporate real estate executives have become more adept at controlling occupancy costs. The prospect of slower job growth, higher energy costs and rising interest rates in 2006 could only compound the problem for landlords.

Job growth plays critical role

For the impasse between lower vacancy and flat rents to be broken, leasing demand must increase — and the only means to that end is jobs. After expanding by 2.2 million jobs — or 1.7% — in 2005, Economy.com expects employment to grow by 2%, or 2.6 million jobs in 2006. And roughly 700,000 new office-using jobs should be created this year alone — a gain of 2.5%. That percentage is expected to hit 3% next year, too.

This low single-digit employment growth has helped buoy the office market. Reis reports that 51 of 69 markets posted positive absorption in the third quarter, down from 54 markets in the second quarter. This activity helped cut the national vacancy rate to 15.1%, down from a peak of 16.9% in early 2004.

Restrained supply growth

Vacancy may still be high from a historical basis, but the chances of a glut materializing next year are remote. Just 35.3 million sq. ft. of fresh supply was completed in 2004, according to Torto Wheaton Research, and that total represented a meager 3% of total inventory (refer to chart at left).

One reason is soaring replacement costs. In October, for example, Armstrong Suspension Systems increased its prices for ceilings by 4% based on rising steel, fuel and transportation costs. And the cost of a standard office suite build-out from shell space in Fort Lauderdale has risen from $28 to $35 per sq. ft. between the end of October 2004 and 2005.

Bach of Grubb & Ellis also believes that higher construction costs will continue to make it more difficult for developers to pencil out new projects. The veteran researcher expects construction prices to rise well above the underlying rate of inflation next year as the massive reconstruction along the Gulf Coast accelerates through 2006.

If development is too expensive, of course, investors may continue to bid up prices on existing properties. Through the end of September, Manhattan-based real estate research firm Real Capital Analytics reports that more than $70 billion of office properties changed hands. That was roughly equal to the total sales volume in 2004.

“The disturbing news is that investors have built aggressive fundamental gains into their thinking, and as a result are outrunning the recovery,” says Lloyd Lynford, CEO of Reis.

Lynford believes that rising interest rates could dampen demand to buy office assets in 2006. But improving fundamentals could generate interest on their own as he believes that many investors will buy on the basis of thinning vacancy and decent absorption. The only catch is that not everyone will win by doing this.

“The reality is that most of the rents that landlords are signing today are a dilution of previous rents from the late 1990s,” says Lynford. “And that suggests that all buildings simply will not benefit from this recovery at the same pace.”