During the late 1990s, the financial services industry spent billions on office leasing and building acquisition costs, and nowhere was that trend more pronounced than in Boston and New York. Simply put, demand was white-hot. The biggest economic expansion in U.S history drove many corporate space users to consume space under the assumption that they would actually need it years later.

It turns out they didn't need it. Massive job cuts in Corporate America led to millions of square feet of empty office space. By last fall, the amount of available space, including sublease space, had ballooned to 540 million sq. ft‥

Still, industry experts believe that the financial services sector will inevitably rebound and spark office leasing demand in Boston and New York. Just when that momentum will occur is uncertain. Few are predicting the glut of office space to disappear overnight, but many believe that 2004 will see a stabilized vacancy rate in these two major metros.

Downtown Manhattan posted a vacancy rate of 13% at the end of third-quarter 2003, down nearly half of a percentage point over the previous year. That suggests government incentives have lured tenants into this market.

Meanwhile, Boston's CBD office vacancy rate hovered at 14.5% at the end of September, its highest office vacancy rate in over a decade. The problem has been compounded by 1.7 million sq. ft. of new office space that was completed last year, according to real estate research firm Reis Inc.

“Everything hinges on these financial services firms. If they sit on the sidelines, it will slow down the recovery,” says Elizabeth Haukaas, director of client services at Grubb & Ellis.

To understand how essential financial services tenants are to Manhattan's office market, consider that slightly more than half of its 175 million sq. ft. of office space — or 88 million sq. ft. to be precise — is leased by financial services tenants. Not far behind is Boston's CBD, which is 33% leased by financial services tenants, according to Grubb & Ellis. Of Boston's 42 million sq. ft. of Class-A stock, 14.1 million sq. ft. is leased by financial services tenants.

“The financial services business is the engine that drives the New York economy, and I just don't see it steaming back,” says Lawrence Fiedler, a real estate professor at New York University.

Fiedler predicts that many of these big firms will even return space to the market once the economy starts to improve. His reasoning is that many of them gorged on new space back in the late 1990s when leasing costs were astronomical. As costs have fallen dramatically over the past few years, keeping that pricey space has become harder to justify — so they sublease it.

“These financial services firms are experts at everyone else's business except their own,” he says, referring to their often unrealistic appetite for space.

Their appetite for new hires has certainly been weak. Between the months of January 2001 and May 2003, New York lost 235,000 private-sector jobs. However, September and October 2003 saw a net gain of 11,100 jobs, which was touted as a key measure of an improving economy. Optimists believe that the improving job climate, combined with strong Wall Street profits, bodes well for the city's economy in 2004.

Mixed Bag in Manhattan

While there were many bright spots in Manhattan's economy last year — the office sector wasn't one of them. Midtown Manhattan's overall office vacancy registered 11.9% as of Nov. 1, which was a 0.9% increase over November 2002.

The New York comptroller reports that Wall Street profits hit $11.96 billion for the period between January and September of 2003. Conversely, the same period in 2002 saw only a $5.85 billion take. While last year's profit increase was impressive, it also stemmed from aggressive cost-cutting measures that have done little to lower office vacancies. The profit increase also came about without any major growth in hiring.

“Many of the financial services firms are carrying plenty of shadow space. In 2004, they will repopulate a lot of that space,” says Robert Freedman, president of brokerage GVA Williams.

Mutual Fund Fallout in Beantown?

Mutual fund tenants lease a full 12% of its Boston's CBD office stock. Now that the biggest mutual fund scandal in U.S history is unfolding, that 12% is feeling the heat. Investors have withdrawn roughly $30 billion from Putnam Investments, the biggest of the Boston mutual funds. Federal and state regulators have accused Putnam of securities fraud.

Sources believe that the mutual fund scandal will have a ripple effect on the office market. “This may not deepen our vacancy rate, but it will delay our recovery,” says Claude Hoopes, a principal at CRESA Partners' Boston office.

Hoopes recalls that in the last recession financial services and the high-tech sector helped revive the commercial real estate sector. “Now everyone is looking for the third leg of the stool — there isn't one.”