The chasm is no longer deepening in the U.S. office market, but the climb back to recovery could still be a long and precarious one. So say national office lessors, developers and data firms as they presage another restrained year in the office sector in 2004.

Kindling some optimism for the coming year was a slender one-tenth of a percentage point drop in the national office vacancy rate to 16.8% in the third quarter, according to CoStar Group. With positive net absorption (13.58 million sq. ft.) in the third quarter exceeding construction deliveries (12.96 million sq. ft.) for the first time in three years, a slow rise in occupancy could be in store for 2004, say industry experts.

“We do believe we are pretty much at the bottom,” says Maria Sicola, senior managing director of research at New York-based Cushman & Wakefield. “And we are asking tenants renewing in the 2004-2005 window to consider that.”

Rents, which slid nationally in the third quarter from $22.12 per sq. ft. to $21.96 per sq. ft. for all classes of space, according to CoStar, should continue to soften well into 2004, says Jeffrey Weil, senior vice president of Colliers International. “We are still seeing huge corporate layoffs, and they have a spiraling effect.”

Ironing Out Market Kinks

Some U.S. firms locked into long-term leases are paying about twice the rent of companies that have recently negotiated market-adjusted deals, says Weil. Their rents will drop in 2004 and beyond when leases expire. Additionally, an abundance of “shadow” or “phantom” office space, so named because of its underuse by tenants, remains pervasive and will be the first to fill when the job market broadens, Weil says. “You walk through an office building now and see at least one out of every seven cubicles empty.” Weil believes that an overall recovery in the office sector won't begin in earnest until 2005.

Dallas-Fort Worth, still reeling from the telecom fallout and oversupply, recorded the softest office vacancy rate in the nation at 21.3% for the third quarter (for all classes of space), up from 20.7% the previous quarter.

Atlanta, with a 17.3% vacancy rate, isn't faring much better. “We still have several years to go before the marketplace stabilizes,” says Scott Taylor, COO of leasing and development for Carter & Associates: ONCOR International. “We led the nation in 80,000 to 90,000 new jobs a year for nearly a decade. The last few years have seen negative job growth.”

The only single-digit vacancy mark was reported by the Inland Empire, the high-growth suburban Riverside/San Bernadino/Ontario region east of Los Angeles, with 9.3% vacancy.

Although the office market's vital signs could hardly be called uplifting, Mitch Rudin, president of U.S. transactions for CB Richard Ellis, expects the market to begin to recover by mid-2004. Rudin is heartened by recent growth in New York's “taking” rents, or final negotiated lease rates, which rose from 83 cents per dollar of asking rents in early 2003 to 86 cents per dollar in late 2003.

Construction Activity Wanes

About 65.2 million sq. ft. of office space is expected to be completed nationally this year, according to CoStar. That's about a 10% drop from the 72 million sq. ft. constructed in 2002. Indeed, the trend is for new office construction deliveries to slow significantly over the next few years. About 53 million sq. ft. of new space will be completed in 2004, according to CoStar.

Among the biggest projects slated to be delivered at year-end 2003 or in early 2004 are the 1.8 million sq. ft. Time Warner Center in Manhattan; the 1.5 million sq. ft. Colgate Center-Goldman Sachs building in northern New Jersey; and a pair of 1.3 million sq. ft. buildings in Chicago, Hyatt Center and ABN AMRO Plaza.

One of the nation's top office developers, Houston-based Hines, says any new development must have top-credit anchor tenants in tow. “In 2004, we will have three projects under way with major law firms as tenants,” says George Lancaster, vice president of communications for Hines.

Concessions Craze Eases

In the San Francisco Bay area, which is burdened by 20% Class-A building vacancy and a 16.7% overall vacancy, some landlords are signing leases at below break-even just to cover operating expenses, says Weil of Colliers International. “How long can that last?”

But the exorbitant tenant concessions are starting to abate in some markets, says Rudin of CB Richard Ellis. Over the last year, it was not uncommon for landlords to grant up to 12 months free rent in a five-year lease deal or offer generous finish-out allowances and additional parking.

Weil of Colliers International adds that some landlords have even offered to pay off prospective tenants' existing leaseholds to gain their business.