The U.S. economy is taking some hard hits from ongoing turmoil in capital markets, plus growing concerns over inflation. But the office market is hoping to escape with only a glancing blow to vacancies and rents.

The national office vacancy rate has increased 20 basis points in the past two quarters to reach 12.9% at the end of March, according to real estate research firm Reis. Even as vacancies have inched higher, effective rents have been on the rise since 2004. Effective rents increased 1.5% during the first quarter to an average of $24.99 per sq. ft.

The problem is that some experts are predicting that vacancies could rise another 1 to 2 percentage points by the end of the year. “What we see is declining absorption over the next few quarters, which will prompt vacancies to rise and rent increases to slow in the coming months,” predicts Arthur Jones, a senior economist at CBRE Torto Wheaton Research.

That estimate appears realistic given the latest round of negative job growth, a key indicator for office demand. Non-farm payrolls fell 49,000 in May, raising the unemployment rate by a half percent to 5.5%, the largest one-month jump since 1986.

The good news is that compared with past cycles, the office sector has not been overbuilt. In 2001 and 2002, roughly 243 million sq. ft. of office space was completed — more than double the roughly 99 million sq. ft. of space built in 2006 and 2007. Owners will likely weather this market downturn by granting higher tenant improvement allowances and free rent rather than lowering rents.

Winners and losers

Although Class-B and C properties will likely feel the biggest impact, Class-A properties are not immune to softening demand. “We are certainly seeing a slowdown from last year. Tenants are rethinking their needs and waiting a little bit to see what's happening,” says Charles Baughn, executive vice president and CEO of capital markets at Hines. Hines ranks No. 4 on NREI's list of top office owners with 55.4 million sq. ft. in its portfolio as of Dec. 31, 2007.

The strength of office markets can vary widely. Markets heavily influenced by the oil and gas sector, such as Houston and Denver, are robust. Demand has been strong and rents continue to rise. Houston's downtown Class-A office market registered a vacancy rate of 6.9% for the first quarter and a 5.7% increase in rental rates compared with the fourth quarter, according to Colliers International. Conversely, markets like Orange County, Calif., and New York have had a noticeable drop in leasing activity. New York is struggling because of its exposure to financial services, while Orange County has been hit by the residential mortgage sector.

In markets battling high vacancies, concessions are rising. For example, Hines is keeping a close eye on its office properties in Southern California. “We are going to do whatever it takes to ensure that we are at market with our leasing terms, and if that involves concessions then yes, we would make concessions,” Baughn says.

Sales remain stagnant

The other major dynamic hampering the office sector is a decline in investment sales. The $13.9 billion in sales during the first quarter was off the white-hot pace that existed a year ago when major portfolio sales helped to push the volume to a staggering $75.2 billion, reports Real Capital Analytics (RCA), which tracks sales greater than $5 million.

The capital crunch, coupled with a gap between bid and ask prices on investment property, has slowed sales to a trickle. RCA estimates the pricing gap between buyers and sellers to be 15% or higher.

“What you're seeing on the investment side is a disconnect between buyer and seller expectations, and a lot of buildings are being pulled off the market,” says Dennis Friedrich, president and COO of U.S. commercial operations at Brookfield Properties Corp., which ranks No. 2 on NREI's top owners list with 59.5 million sq. ft. in its portfolio at the end of 2007.

Brookfield has pursued about 15 office acquisitions over the last six months. Eleven of those properties have been pulled off the market by the seller.

Still, the property sales market is not quite dead. Hines recently purchased a 1.5 million sq. ft. tower in Houston for $271.5 million. Many hope that the logjam in the investment market will loosen up by the end of the year. “We are seeing some select opportunities, where a seller, for whatever reason, does need to sell,” says Baughn.