Office owners couldn't be happier that the long, dark night of poor to marginal real estate fundamentals that led to a strong tenant's market has nearly run its course. While the national vacancy rate is still well into double digits — approximately 14% in the first quarter — that figure is down 60 basis points from the end of 2005 and marks the eighth consecutive quarterly drop.

Effective rents rose 2% during the same period, the fastest quarterly increase since the office slump began in 2001, reports data provider Reis Inc., which tracks 69 metro office markets nationwide. Effective rents rose to $21.06 per sq. ft., the highest level since the fourth quarter of 2002. Fifty-nine markets posted higher effective rents, according to Reis.

Demand for space in the first quarter of 2006 led to 15 million sq. ft. of office absorption nationally, compared with 10.5 million sq. ft. in the same quarter last year. Vacancies fell in 56 markets, and 50 markets posted positive absorption.

“While companies spend money on other things before they get around to expanding their office space, they're doing that now,” says Bill Tresham, COO of Trizec Properties.

The company ranked No. 5 on NREI's list of the Top 25 Office Owners survey with about 34.6 million sq. ft. of office space in its portfolio as of Dec. 31, 2005. Trizec will merge into a Brookfield Properties-Blackstone Group joint venture later this year.

The equation has flipped to a landlord's market, especially in New York, where scant new development is underway, says Tresham. “Demand is so strong throughout downtown and Midtown and even Jersey City that asking rates and effective rates are about the same,” he says.

Development in check

In previous cycles, a ramping up of office absorption would have developers chomping at the bit. Thus far, development hasn't responded by taking a great leap forward, just an incremental rise.

In the 42 office markets tracked by brokerage Marcus & Millichap, a median of 0.5% new space will be added by the end of 2006. New deliveries will generally increase compared with 2005. In northern New Jersey, for example, 500,000 sq. ft. of new space will be delivered this year, compared with 266,000 sq. ft. last year.

Rising construction costs continue to keep development in check. “On top of last year's increases, that puts a damper on the amount of development that gets done,” notes Tresham. The price of cement as of June 2006 is up 8% from a year ago, while the price of steel is up 8.4%, both outstripping the general inflation rate.

The Washington, D.C. market is an exception, with 7.6 million sq. ft. projected to come on line this year, spurred by government expansion, an increase from last year's total of 4.6 million sq. ft. Yet demand is so strong in the nation's capital that Marcus & Millichap predicts that vacancy will register 9.4% at year's end, down 40 basis points for the year.

Buying the fundamentals

Office investment has been strong in recent years as capital yearns to find a home. According to Marcus & Millichap, the office sector now offers buyers cap rates of about 7.7%, down 60 basis points from a year ago.

That's still higher than the average cap rates for retail and multifamily properties, 7.3% and 5.9% respectively. With improving office fundamentals, however, investors are seeking properties that will rise with the economic tide.

Part of the sales volume recently has been, and will probably continue to be, through acquisitions of large office owners, such as the late spring purchase of Trizec and Trizec Canada by a Brookfield/Blackstone, or the high-profile acquisition of CarrAmerica by Blackstone earlier in the year. But buyers are also on the prowl for one-off opportunities.

“We've been selling a variety of single-tenant properties and buying multi-tenant office properties,” says David Cobb, CEO of BentleyForbes, a California-based investor, explaining that he believes that any potential for rent growth in the single-tenant market is limited by the long-term nature of many of the leases.

Even Chicago, long a weak market, is attracting buyers now because of improving fundamentals. In the suburbs, Equity Office Properties Trust ended an 18-month hiatus of office acquisition in its hometown this spring with the purchase of the 263,000 sq. ft. Pointe O'Hare in Rosemont, Ill., for $57.6 million.

“We're interested in making acquisitions in submarkets with strong fundamentals, such as the O'Hare market,” says Lyle Patterson, director of investment for Equity Office, No. 1 among this year's Top 25 Office Owners with 101.3 million sq. ft. “Many suburban Chicago markets are making a distinct comeback.”