When will vacancy rates return to normal and asking rents stop falling? The answer very much depends on how quickly the office market can clear out a whopping 124 million sq. ft. of sublease space — about 25% of the total available space nationwide.
Until that sublease space is re-absorbed by prime tenants or re-rented, there is little reason to expect demand for prime space to pick up. In fact, some economists and researchers believe it will take until mid-2006 or 2007 before the office sector returns to the point of equilibrium — or a 10% vacancy rate — largely due to the glut of sublease space.
The sublease overhang, created by retrenching dot-coms and downsizing corporations, is making this economic downturn painful for owners of office properties. The industry may not have overbuilt during this current cycle, but it hardly seems to matter. “Demand became so vastly and sharply negative that it's a moot point,” emphasizes Bob Bach, national director of market analysis at New York-based Grubb & Ellis. “The bottom line is the market fundamentals stink, and they are at about the same point they were 10 years ago.”
The national office vacancy rate, estimated to be 17.5%, is nearly as high now as it was a decade ago, according to Bach.
Sublease space typically rents for 20% less than direct space in major CBDs because tenants facing financial pressure are not nearly as demanding as landlords when it comes to asking rents, says Robert Freedman, vice chairman of New York-based GVA Williams Worldwide. “Vacant space is a wasting asset. The tenant will do anything to find someone to sublease it,” says Freedman.
But owners wind up paying the price. Eventually, they have to drop asking rents to attract tenants who can choose from a nice inventory of cheap sublease space. Landlords may have a lot of price cutting to do now, since many of them tried to hold the line on prices last year, only to see vacancies rise. “Up until only three months ago, they weren't bringing their rents down to compete with cheaper sublease space,” says Bill Maher, national director of research at Jones Lang LaSalle, Chicago. “Only recently have they lowered their pricing to compete.”
There is another cruel twist to the sublease situation. Rather than see more sublease space in their properties, landlords will take back space from prime tenants by terminating leases. But the end result, says Elizabeth Ptacek, senior analyst of market research for Pittsburgh-based PNC Real Estate Finance, could be an increased number of distressed landlords. “That has more of an implication for the sales market,” she says. “With more troubled properties, you may begin to see the sales prices decline.”
Cutting the Glut
The growth in sublease space has been dramatic since the economy softened. In 1998, sublease space accounted for 5% of the total amount of available office space, according to Grubb & Ellis.
Today, that figure stands between 20% and 25%. The tech wreck has accounted for more than 40% of all sublease offerings, according to researchers.
So how fast will the market work off this sublease glut — and move toward normal occupancy rates? Not quickly. According to New York-based Cushman & Wakefield, the amount of available sublease space registered 123.7 million sq. ft. at year-end 2002, compared with 108 million sq. ft. the year before. Since second-quarter 2002, the volume of sublease space has declined only slightly (see chart on page 22). With time, lease expirations will naturally burn off some of the sublease inventory. But it will take more than that to start chipping away at high overall vacancy, says Grubb & Ellis' Bach, who figures that if all the office sublease space were to be absorbed, the national vacancy rate would drop only to 14%.
It all boils down to basic demand and that, in turn, depends on the economy. For now, the picture is not great. “The problem for landlords is we're nearly 20% vacant in some markets, and there's no demand,” says Jones Lang LaSalle's Maher.
Indeed, statistics show sublease space isn't being absorbed quickly. From 2000 through second-quarter 2002, sublease space accounted for only 9% of total leasing activity. “The existence of sublease space will prolong the market recovery because very little of it is being leased,” concluded a report by Ptacek of PNC Real Estate Finance and Bach of Grubb & Ellis released in the summer of 2002. The report, “Office Market Trends: The Sublease Issue Exposed,” surveyed landlords andin 34 markets around the country.
|4Q 2000||4Q 2001||2Q 2002||4Q 2002|
|National vacancy rate||9.1%||15%||17.4%||18.3%|
|Total space available in millions of sq. ft.||240.9||411.8||487.8||519.2|
|Sublease space available in millions of sq. ft.||41.6||108.0||126.3||123.7|
|Sublease space as % of vacancies||17.3%||26.2%||25.9%||23.8%|
|*As of fourth-quarter 2002, non-CBD sublease space accounted for two-thirds of all available sublease space.|
|Source: Cushman & Wakefield|
One place where sublease space is being gobbled up is in New York City, where some of the biggest leasingin 2002 involved subleases. Morgan Stanley subleased 300,000 sq. ft. from Penne & Edmonds at 1221 Avenue of the Americas. Also, former World Trade Center tenant Aon subleased 242,000 sq. ft. from ABN Amro at 55 East 52nd St. Nearly 19 million sq. ft. of Manhattan office space was leased in 2002. Of that total, Insignia/ESG reports that close to 7 million sq. ft. was subleased.
Murky Job Picture
For the sublease overhang to go away, the office market needs to see job growth. While the number of announced layoffs has dropped, job creation remains weak. Outplacement specialist Challenger, Gray & Christmas reports that in December 2002 employers announced plans to cut nearly 93,000 jobs, vs. 157,500 in November. For all of 2002, job-cut announcements totaled 1.47 million, second only to the record of 1.9 million in 2001. Meanwhile, overall unemployment is stuck near 6%.
|San Jose, Calif.||37.56||35.40||-5.8%|
|Source: Grubb & Ellis|
In the Northeast, the financial services industry has been particularly hard hit. In Boston, Fidelity Investments dropped 170,000 sq. ft. of space onto the sublease market last fall after eliminating nearly 2,000 employees. All told, Fidelity is in possession of 700,000 sq. ft. of vacant sublease space on the Boston market, more than one-third of the city's 2 million sq. ft. of available sublease inventory.
Peter Linneman, Albert Sussman professor of real estate at the Wharton School of Business in Pennsylvania, predicts that it will take three years to return to the peak employment levels of early 2001. Since that time, the economy has suffered a net loss of 1.8 million jobs.
It won't be until late 2006 or early 2007 that the national office vacancy rate dips to 10%, according to Linneman. His “fast math” takes into account the fact that the new development under construction — which won't be completed for another 12 to 18 months — represents 2% of the total inventory of U.S. office space.
Assuming no new demand for space in the short term, that means the true vacancy rate is closer to 19.5%, not 17.5%, as reported by Grubb & Ellis. “In a good economy, you absorb 2% to 2.5% per year,” the economist explains. “If you do the fast math and you have four years of absorption at 2% to 2.5%, you're down to 10%.”
Linneman criticizes lenders for falling victim to all the dot-com and technology hype of the late 1990s. “They did a miserable job of credit underwriting,” he says of the commercial real estate finance community. “The lesson learned is that if you're in the business of committing space that lasts a long time, understand the credit of the people you're going to lease to. The lenders went along because everyone believed in the bubble.”
Practical and Creative Solutions
Owners that don't have sublease problems of their own can do little about the downward pressure on rents that the glut exerts.
But some landlords with sublease problems are taking aggressive steps to clean up the mess and take back their space. Chicago-based Equity Office Properties Trust (EOP), for example, terminated more than 3 million sq. ft. of leases during the second and third quarters of 2002. Chris Mundy, vice president of strategic planning and operations for EOP, says that these lease terminations are designed to “get what you can out of a bad situation.”
EOP's flurry of lease terminations during the second and third quarter of last year totaled $140 million, almost 10% of its funds from operations (FFO) through Sept. 30, 2002. David Harris, a REIT analyst with Lehman Brothers, says that EOP expects to collect $20 million in lease termination fees in 2003. But there's a price to pay: Equity Office's portfolio occupancy rate fell to 89.2% in the third quarter, down from 90.7% at the end of first-quarter 2002.
Nearly $100 million worth of Equity's 2002 lease termination fees stemmed from technology-related tenants on the West Coast. Last fall, tech firm Inktomi paid Equity $54 million to terminate its long-term lease in a brand new California office building. And a few months earlier, Sun Microsystems paid a staggering $85 million to get out of its lease at an Equity-led development in San Francisco. Equity pocketed $40 million of that sum.
Still, Equity is at least dealing with the problem. Harris believes that many office REITs have not yet recognized the magnitude of the sublease glut. Lehman Brothers has posted a negative outlook for all big office REITs with a high concentration of property in CBDs. “It's really surprised us to see the volume of lease termination fees remain very high for so long,” says Harris.
Other landlords prefer to avoid lease terminations. “We're not actively doing any buyouts to get control of space,” says Mark Cover, a senior vice president at Houston-based Hines. “We're still focused on our direct space and how to market that space to companies.”
Hines owns or manages nearly 50 million sq. ft. of CBD office space nationwide, with an overall vacancy of 13.4%. “The only way that sublease can really compete well with direct space is if the [original tenant] has good credit. The subtenant has to consider the term on that lease, which might be very short,” according to Cover.
What Tenants Want
Because cheap rent frequently isn't enough to attract prospective subtenants, other enticements are beginning to emerge. Sublessors, for example are offering so-called “plug and play” space that is outfitted for immediate occupancy, says Don Rodie, a senior director at Cushman & Wakefield's Phoenix office.
“It's sometimes possible to get a higher rate on this sublease space because it's less of a hassle for the subtenant who needs to move in fast,” explains Rodie. The veteran real estate broker adds that he spends 85% of his time working with corporate users to market sublease space.
Ptacek of PNC Real Estate Finance says she was surprised to learn through her research that large, credit tenants are typically not interested in sublease space. “From a tenant's perspective, we expected sublease space to be attractive because it was nice, new space offered at rates well below market rents,” says Ptacek. Sublease space is generally high-quality real estate. Class-A space accounts for about 62% of the total inventory of sublease space compared with 38% for Class-B and -C space, according to Ptacek.
But in the eyes of many credit tenants, sublease space poses several limitations. For starters, the terms on many subleases are for only three or four years, which is perceived as undesirable by many credit tenants who prefer longer leases. The average lease term on sublease deals signed between April 2001 and June 2002 was 38 months compared with 58 months for direct deals, based on Grubb & Ellis and PNC Real Estate Finance research.
Another potential deterrent for prospective subtenants is that tenant improvements are rarely available and the space typically can't be subdivided, says Ptacek.
An Uneven Recovery Ahead
While all office markets are experiencing some softness, Wharton's Linneman believes that metro Washington D.C., Philadelphia, San Diego and Los Angeles will be among the first to recover. On the flip side, Northern California — including San Francisco, San Jose and Silicon Valley — will lag, he believes. Indeed, Washington and San Diego have benefited from heavy defense spending in recent months, and the prospect of a Gulf War may even bode well for these markets.
In San Jose, however, the vacancy rate for all classes of space at the close of last year was a whopping 27%, based on Grubb & Ellis data. Rents have fallen in San Francisco to a six-year low of $29.44 per sq. ft. And in Atlanta, where the telecom sector boomed during the late 1990s, both CBD and suburban Class-A vacancy is higher than 20%.
The positive side to the sublease problem is that, potentially, this space can be absorbed much more quickly than direct space. When the economy gains momentum, tenants with vacant sublease space may examine their business prospects and realize that expansion is no longer out of the question. The so-called shadow space will then be re-absorbed by the tenant.
“It's not so much demand that will drive this either,” says Peter Turchin, managing director at Insignia/ESG's New York City office, referring to shadow space. “Firms will just take it off the market and hold onto it.”
The economy must create more than 1 million new office jobs in order to scale vacancy back to 10% nationwide, according to Grubb & Ellis and PNC Real Estate Finance. That forecast assumes steady job growth over the next four years and no additional construction starts. Right now, that's a tall order.
The report from Grubb & Ellis and PNC Real Estate offers hope. “Sublease space is likely to return to the market in evenly spaced chunks over the next five years and beyond.” According to the researchers, 19% of sublease space is expected to expire in 2003. “It could be described more as a drag on the office market's recovery than as a trap waiting to ambush landlords and investors.”
SUBLEASING PROS & CONS
Costs approximately $8-$10 less per sq. ft.
Potential of short-term lease
Less scrutiny of credit
At risk of being evicted if the sublessor goes bust
Inherited terms and conditions
Limited tenant improvement package
Potential to upgrade tenant credit
Possibility of additional cash flow
- Direct-space competition
- Impact to building value
- Limited control over sublessee
Source: National Association of Office and Industrial Properties