Office fundamentals have been posting consistent signs of recovery, with national vacancies falling by 30 basis points over 2011 to end the year at 17.3 percent. National effective rents have also been crawling upwards, rising by 2 percent. The risk that office properties will post income declines as leases roll over, however, is particularly high in 2012.

Leases for office space are generally signed for average terms between five to seven years; this tends to protect office property income from downturns, unless tenants renegotiate. Unlike hotel and apartment properties, which have average lease terms of one night and one year, respectively, expected income from office space need not be marked to market until leases are renewed. Unfortunately for the office sector, five-year leases signed in 2007, when rent levels peaked before the recession sent them plunging back down again, are coming due this year.

Not all office markets face the same risk. About 27 percent of buildings in Reis’s national database of office properties have average lease terms of precisely five years, but some markets have an outsized proportion of properties with five-year lease terms. Combine that with effective rents that are still well below 2007 peaks (despite some improvement in recent quarters), and the risk increases substantially.

“High beta” markets: A cautionary tale

Even “superstar cities” like New York and San Francisco offer cautionary tales for investors in office properties. These two metros are at the very top of our rankings for effective rent growth in 2011, with rent levels rising by 4.8 percent and 8.6 percent over the year. New York benefited from its usual supply constraint and rising demand for Manhattan CBD office space; the resurgent tech sector buoyed effective rents for San Francisco office space.

However, despite these improvements, every submarket in Manhattan posted effective rent levels that fell anywhere from 8.7 percent to 20.7 percent below peak values attained in 2007, when overall metro rents grew by over 25 percent. After all, the downturn hit New York City in a particularly devastating way, with effective rents falling by close to 20 percent in 2009--not surprising, given that the Manhattan office market bore the brunt of the financial services meltdown.

San Francisco fared relatively better, with some submarkets like Union Square and Waterfront/North Beach now boasting rents above 2007 peaks. However, the tech sector wasn’t at the epicenter of the last downturn; when San Francisco served as the poster child for the tech bust back in 2000, office rents rose by 54 percent in a single year, only to endure declines for four straight years. Effective rents ended 2011 at $32.30 per sq. ft., a far cry from 2000 peak levels of $58.33 per sq. ft.

Factors that mitigate and exacerbate

The sky isn’t about to fall for office properties around the nation. “Not every single lease will roll over, so most properties will have some breathing room as existing leases continue to provide stable income,” notes Dan Quan, head of quality control at Reis. “After all, we muddled through 2011, when five-year leases signed at relatively high 2006 levels had to be renewed.”

Still, some properties that have large tenants will find it challenging to renew leases at rent levels signed prior to the downturn. A January Wall Street Journal article, Trouble is Brewing for the Office Market, profiled specific buildings that are facing an uphill battle when it comes to keeping tenants at rent and occupancy levels at which they underwrote development plans three to four years ago. If leverage was used to finance the purchase or development of particular properties, required fixed payments will magnify the effect of income declines.

Reis expects office fundamentals to continue recovering at a measured pace throughout 2012. Unfortunately, that means that improving rents and occupancies will not come soon enough for 2007 leases to be renewed in an accretive fashion this year. Overall recovery patterns may not be derailed, but specific office buildings will have to face challenging times because of rollover risk until the economy gets back on more solid footing.

Victor Calanog is head of research and economics for New York-based research firm Reis.