The question posed to leasing executives and investment analysts about today's office market isn't whether this real estate segment is in a recovery stage (almost to a man they believe it is), but rather how quickly will things return to single-digit vacancy rates and rents able to support development.
Most indicators used to gauge the market -- vacancy rate, rents, property values -- are all improving, both on a national basis and in key markets that figured to be on the leading edge of the recovery.
Organizations that track overall national office vacancy figures currently place it between 16% and 18%, but the national office market is greatly fragmented by a number of factors including region, urban vs. suburban locations, class of space, and the strength of the local economy.
Each of these factors are producing varying results in this recession, which complicates estimates of the overall recovery. As a consequence, estimates on when the office market will completely recover range from 18 months to early in the next century.
"The office market is coming back, there is no question about it," says John F. Powers, executive managing director at New York-based Edward S. Gordon Co. "But the office market is not homogeneous, it is not coming back in every market segment at the same rate, or at all yet, in some cases."
"While a few markets are inching their way upward, others are simply seeing a slowing in their rate of decline, but, in general they seem to be stabilizing," adds Rick Pederson, spokesman for Houstonbased Oncor International.
While the health of the office market varies greatly, from segment to segment, Pederson does see some geographic trends in the recovery.
"The Rocky Mountain region has led the way," he says. "Part of the reason is it was among the first areas into the recession about a decade ago. Next would come the Southeast, anchored by Atlanta, although all of Florida is starting to look strong as well. The Northeast and the Midwest would follow about neck and neck, definitely behind the Southeast but doing better." He says the laggard is the West Coast, although both Portland and Seattle held up better than.
The positive indicators showing up in the stronger markets include an increased interest in purchasing office properties, a decrease in the amount of tenant concessions offered, stirrings in the build-to-suit market and increases in occupancy rates and rents.
One reason cited for increased office occupancy is an expected growth in office employment. "There will be some growth in population, the percentage of agricultural and industrial jobs is declining and more people will be working in the service sector," explains Powers. "All of these factors will result in a positive net growth in the office sector."
Employment growth impacts occupancy
John Dowling, executive vice president with New York-based Cushman & Wakefield, agrees, estimating the growth at between 1% and 2% a year during the next decade. "That's only about half of the growth we had during the 1980s, but that was when the baby boomers were coming through the work force."
Top Markets For Primary Office Employment Growth (1994-2004)
Source: Cognetics Inc.
Others, however, are more cautious, feeling corporate downsizing and business trends could lead to less of a demand for office space. "Even if the number of people employed in offices increases, if companies continue to increase efficiency by reducing the net square footage per employee, vacancies will not be absorbed," cautions Ivan Faggen, worldwide director of the real estate services group at Los Angeles-based Arthur Andersen & Co.
"I think the more important aspect of that question is the effect the different trends in business will have on space requirements for workers," says Steve Pope, senior vice president and director of marketing for Los Angeles-based Grubb & Ellis. "Hoteling (workers traveling more and spending less time in the office) and telecommunting (working at home) are all things that will negatively offset any increase in office employment."
Pederson agrees these factors are diluting the impact of employment growth, but does not agree they will totally negate them. "We are not seeing new office employment translate as neatly into new office absorption as we did a decade ago, but we are seeing positive office absorption due to employment growth."
"Corporate downsizing is still in process, but I think the most radical corporate downsizing has taken place," says Robert L. Freedman, vice chairman of New York-based Williams Real Estate Co.
Dowling agrees, saying the effects of corporate downsizing are being greatly overestimated and that the low cost of space in relation to other business expenses means it is an area in which companies will be willing to splurge. "While we are hearing all of this talk about companies cutting the amount of space per employee, what we are seeing is a slightly expanded square footage per person," he points out. "With white-collar computer-oriented employment so competitive one of the things companies do, as an enticement, is increase the entitlements and give people a little bit more of an office."
But the last few years tenants have taken on more than a bit of additional space and this has created problems in the market.
Low rents encouraged many office tenants to take more space than needed. But as the recession lingered, squelching plans for growth, many companies tried to cut their losses by subletting the additional space, usually at rates below market. Another tier of the office market was created, slowing the reduction of vacancy rates, and, in turn, keeping rents low.
"Companies are making this space available at much lower rates because they are just trying to stop the bleeding," says Steven Goldstein, executive vice president of New York-based Julien J. Studley. "Corporate downsizing and lease takeovers (where landlords take over a tenant's lease to get them to move into new space) are the two contributing factors to the sublease market."
In some cities, vacant space entering the market, of which a large portion is sublet space, is swallowing up gains made through new leasing. "In the midtown New York office market, we rented 16 million sq. ft. in the last nine months of 1994, which is more than in all of 1993," says Dowling. "Yet we still have a negative absorption in Midtown. More space came onto the market than went off, and that is without any new construction."
Year-end 1994 statistics
"The availability of sublet space is a consistent problem in most markets," says Pederson. "As long as viable sublet space is available at a lower rate, it will keep the market from moving."
"The sublet market is a problem," admits Gary Beban, president of Los Angeles-based CB Commercial. "But we are noticing an increase in the absorption of sublet space by expanding middle market companies and new firms."
Positive signs are noted
These increases in absorption and occupancy have led to the next positive step in a recovery, the reduction of tenant concessions. While these concession packages of free rent and tenant allowance money are still part of the leasing equation, the amounts offered have decreased significantly.
"The packages aren't as large," says Beban. "If you had been getting two years free rent in the past, now you might be getting six months. The tenant allowance per square foot is also dropping, so in general the value of the tenant concessions is being reduced on all fronts."
"Concession packages are tightening up in various markets," agrees Phil Royster, president of the Pacific Southwest Region of Grubb & Ellis. "We haven't seen any upward movement in actual rents, but there has been a definite firming in the amount of concessions offered."
In addition, the creditworthiness of tenants is once again coming under scrutiny and lease flexibility issues, such as the tenant's expansion ability and freedom to terminate the lease, are costing a higher price, if available at all. "All of this is due to the landlord feeling as though he is in a better position than in the past and so he is drawing the line in the sand a little deeper," says Steven F. Stratton, executive vice president of Chicago-based Tanguay-Burke-Stratton. "Transactions are getting tougher to complete now, since both sides have some bargaining power."
Bargaining has also re-entered the market for buying and selling office properties.
"I think one of the indicators of the strength of the office market," says Julien J. Studley's Goldstein, "is that property is being offered for sale now. And no longer at bargain basement prices, but at cap rates that reflect a stronger economy and a confidence in the economy gaining strength in the future."
The rise in pricing is due to increased competition. "We were not able to get bids on properties 24 months ago. Today, we get multiple bids," recounts Beban.
"Office has come from an asset category that was not considered a prudent investment three years ago," stresses Pederson, "to one that interests high-risk entrepreneurial investors, and the institutions, as well, in stronger markets."
Investor interest increasing
"The perception of the office market by institutions has turned and so they are playing a different ballgame," says Stratton. "Their interest is growing."
"The Eastern seaboard office markets are showing excellent strength in both downtown and suburban markets," says Marty Levine of New York-based Koeppel Tener Real Estate Services Inc. (KTR) "The reappraisals we are doing on our clients' portfolios are showing much lower vacancy rates and double-digit growth rates in effective rents from a year ago."
Cushman & Wakefield is currently selling three office buildings in New York "at prices no one could have predicted a year ago," Dowling says. "There is real equity, domestic and European, looking at all of the markets. And that is a good indication of the market returning."
Goldstein says Julien J. Studley recently sold a property at a 7.5% cap rate and he has heard of other sales with cap rates as low as 6.5%. "Nobody invests money to get a 6.5% return," he says. "They are [buying] because they expect the market to get better, leading to increases in rents, in property value and the cap rate to 10% or 11%."
Other agree. "For the better classification of properties we are seeing investors, not speculators, who are buying at defensible cap rates based on some releasing assumptions, that for the first time are starting to compute," says Freedman. "There is clearly an appetite for office properties as an asset class."
This appetite has resulted in some substantial offers for properties.
"It is surprising," says Lawrence Fagnoni, managing vice president of Newark, N.J.-based Prudential Realty Group, "in the Washington, D.C., market we have had some offers for office buildings of more than $300 a foot, those are the kinds of numbers we used to see in the mid-1980s."
But he warns that, at this point, the interest in properties is specific to certain markets and particular segments of those markets. "We are definitely in a stage of the recovery, but not a strong stage, where investors are out chasing every segment of every market."
Another reason for the renewed interest in office properties is that other investment options are not as attractive as a few years ago. "The stock and bond markets each have their own problems that have scared off investors and made real estate look like a better alternative," says Jim Ryan, senior vice president with KTR.
"We are very positive about the investment market," says Terry Tener, KTR's director of valuation services. "We think what is going on today is just a catch-up situation. The early 1990s represented a period of time where assumptions about investments were very conservative, which held down value. But today we are in a much healtheir forum allowing real estate to become a valid investment."
For certain property types the buyers are beginning to outnumber the sellers. "As appraisers we are being approached frequently by our clients who are telling us they cannot find product," adds Levine. "There are not enough good buildings with cash flows that are readily available for sale."
Interest in acquiring office properties has included Class-B and Class-C space, which, although being called technologically obsolete for some uses, in certain markets presents a greater opportunity than Class-A space.
"In some cases we are seeing a very narrow focus on Class-B product, by buyers, as a risk-adjusted better investment than Class-A," says Pederson. "It is still functional product for a wide band of tenants and, at its significantly reduced price, the rate of return may be higher than Class-A space."
In other instances, companies are buying well-located Class-B properties and renovating them for their own use.
As an example, Grubb & Ellis' Pope cites CBS' purchase of The Ed Sullivan Theater for the staff and production crew of The Late Show with David Letterman. "They had to spend a small fortune in getting that building up to grade to handle all of the communication and studio functions," he says. "It was truly Class-B space when they started, however, now they are attracting high-end clients for the remaining space because of the name behind it and because they really were able to upgrade the space's capability."
Goldstein says the same kind of projects are being completed on Class-C space without the high-profile tenants. He cites these renovation projects and the fact that institutional capital is available in the equity and debt markets to finance them, as more positive indicators of the recovery.
"Bankers have called these projects 'speculative' office buildings," he says. "These [Class-C] buildings are being renovated, restored and offered for lease, and the developer had to go through all of the traditional methods of development short of building the building. The bankers say, 'If that is not a speculative office building, what is?"
"The financing of these projects has to do with lending institutions that believe the availability of supply in these downtown markets is insufficient to meet the demand and there is reasonable optimism to reflect that."
More specifically it is the lack of large blocks of contiguous space. This is seen by some as a sign of the end of a bad cycle in the office market and another step closer to new development.
The theory, says The Edward S. Gordon Co.'s Powers, is that when institutions take over failed office properties, to increase the cash flow immediately, they lease space without regard for the marketing of the rest of the building. "For example," explains Powers, "if you have a 500,000 sq. ft. building and you do two 60,000 sq. ft., depending on where the two tenants are located in the building and the expansion rights given to the tenants, there may be left, at most, a block of 380,000 sq. ft. or blocks of under 200,000 sq. ft." He says as this continues large amounts of space are "cut up" into spaces too small to meet the needs of the larger, usually better-credit, tenants.
This lack of large space makes overall vacancy numbers in a market irrelevant in many cases. "There may be a 15% office vacancy in a particular market," points out Royster. "But if you are a tenant with a 50,000 sq. ft. requirement, the vacancy rate you are dealing with may only be 3%, 4% or 5% because there are only a few buildings with those amounts of contiguous space available."
"In Minneapolis, for example, spaces of 50,000 sq. ft. or greater are virtually non-existent," says Stratton.
Often this lack of large space leads companies to other options.
"When these major users can't find what they are looking for they move to the build-to-suit market," says Powers. "That is the start of the development cycle and it is happening today."
In addition to being a signal of new development, build-to-suits also have a positive effect on rents.
"It really takes a build-to-suit market to accelerate rental rates quickly," says Pederson. "For example, I can move into a building in north Dallas at $12 a foot net, but to get a build-to-suit built would cost $15 a foot. And if I am willing to pay $15 for a build-to-suit, I'm obviously willing to pay $15 in a spec building as well. So the build-to-suit market drives up rents and is a good indicator that spec development is just around the corner."
But "just around the corner" probably means two to three years with the current recession as rents have a long way to go. "To develop in New York, rents would have to come in at about $55 a foot," says Dowling. "Right now rents in midtown New York are around $35."
Even the strongest markets are not yet prepared for substantial spec office development. "Phoenix is one of the best office markets we are seeing right now, but rents are still a couple of years away from justifying the construction of spec office space," admits Royster.
But improvement in the office market has made it easier to build select projects in particularly strong market segments. Goldstein points to the Houston-based Gerald Hines organization (Hines Interests Limited Partnership), which has optioned a site in Washington to build a new office building. "The building is capable of delivering 250,000 sq. ft.," he says. "A year ago, the requirement for preleasing would have been 60%. Today, that landlord has indicated that 20% preleasing is all it will take to get the project started."
"Build-to-suits will be the majority of development right now and a lot of them will be started in 1995 and 1996," says Powers, "but they will be built in the suburban markets, not the urban areas."
This focus on the suburbs is due to the strength these markets have shown in many areas in spite of the recession. Although some suburban office markets are as weak or weaker than downtowns, in most areas, the suburbs are firming up as companies continue to leave the high taxes and inconveniences associated with the CBDs to get closer to where their employees live.
"Take downtown Manhattan, downtown Chicago and downtown Los Angeles, just as examples," says CB Commercial's Beban. "They are still in a very high vacancy position, whereas their related suburban areas have had significant absorption during the year." He points to CB Commercial statistics showing vacancy rates moving down by more than 3% since the third quarter of 1991, despite the inclusion of what he calls "weak results" from downtown markets.
"We are trying to pare down our CBD exposure," says Fagnoni. "We are much more optimistic on our suburan office buildings, particularly those in office parks."
"I think it is clear that [the strength of the suburbs] is part of the whole movement out of the central core," says Royster. "People want to work closer to where they live. It is ease of commuting and other issues."
These other issues include lower operating costs.
"The CBDs have what is known as the poverty handicap," explains Cushman & Wakefield's Dowling. "The cities are strapped with the cost of infrastructure and the poor, which means higher taxes." He adds that, as companies compete for the best employees, locating near good housing and better schools will be a distinct advantage.
However, the growing strength of suburban markets and the weakness of the CBDs have led to a reversal of past business migration trends in some markets, which is helping tenant the CBDs.
"In Los Angeles, we are seeing tenants that went to the suburbs because of the downtown now because it is cheaper," says Arthur Andersen's Faggen. "I have never seen that before, especially over matters of price."
Beban says he doesn't think this will become a trend, but he does expect it to become a more frequent happening in markets where the suburbs remain strongest. "We saw it in Chicago a few years ago, and I don't think it is going to be as rare an occurrence as once assumed," he says.
Whether CEOs prefer the suburbs or downtown, there is no debate that they want quality space. Depressed rents have made the differential between Class-A and Class-B space so small that many former B space users have already moved up in class. This flight to quality has tightened the Class-A segment nationwide and led to new development.
In Atlanta, where the vacancy rate for Class-A space is 13.5%, Equitable is planning a 24-story, 575,000 sq. ft. office building called Monarch Tower at Monarch Centre. "Atlanta is a front-runner in the rebound of the office market," says Richard T. Nash, marketing manager for Monarch Centre, who points out that specific submarkets are even stronger. "Buckhead, where the new building is being planned, has an 8% vacancy rate."
To prove that there was a demand for office space in the market, Equitable leased two floors of its own space in another office building adjacent to the new building site. That office building, Monarch Plaza, has been 98% leased since opening.
Equitable plans to take 30% of the new space for its own offices, and an additional 20% has been preleased to professional service tenants, says Nash. Ground is expected to be broken on the project in May, when preleasing should have reached the 70% target. Delivery of the new building is scheduled for the first quarter of 1997.
The tightening in Class-A space has been enough to justify increased rents in some markets. "We are starting to see more price differentiation between Class-A and Class-B space now, in many markets," says Powers.
But some think the strength of Class-A space is not going to cure the market by itself.
"In Houston there was a major move of tenants from Class-B to Class-A space," says Faggen. "It tightened up the Class-A market, but in the end it had no significant effect on the vacancy rate for the city."
"In my view, an office market is not healthy until you have at least two classes of space being absorbed," explains Pederson. "What we have found is that, as the Class-A market strengthens and its rents began to rise, Class-A tenants moved back to Class-B space and balanced the market again." He cites Denver, Phoenix and Boston as markets where this has occurred during the past three years.
However, Freedman sees the move to Class-A space as a first step. "Market recovery is sequential. The recovery of Class-B product will start when you have, first, a significant price difference between Class-A and Class-B space and, secondly, when you have job creation. Job creation is what we are waiting on." So in that regard, he says, the market is subject to the strength of the local economy. But he insists the flight to quality that is tightening the Class-A market will take care of the first step by increasing the price gap between Class-A and Class-B space.
While opinions on the recovery in the office market range from hot to cold, the consensus is there is a recovery under way. The hold on new construction the past four or five years has made it easier for demand to catch up with supply and, although the imbalance still exists to varying degrees in many markets, most followers of the office market feel the future looks good.
"But it's not a six-month future," stresses Royster. "It is two or three years down the road."