Office landlords have enjoyed falling vacancies and rising rents during the past three years. But the sector's underlying property fundamentals are likely to weaken due to a softening U.S. economy and a wave of new office supply.

As it stands today, the sector is performing well and there are few signs of stress. The national vacancy rate fell by 20 basis points to 12.5% in the third quarter, its lowest level in six years.

Buoyed by tight vacancy, Manhattan-based real estate consulting firm Reis projects that average effective rents will register $24.57 per sq. ft. in 2007, up 10.4% for the year.

But new supply promises to cut into those strong fundamentals. Developers are projected to build 58.6 million sq. ft. of office space in 2007, up sharply from 44.9 million sq. ft. in 2006.

“The next few quarters will be far more difficult than the last couple of quarters in terms of fundamentals [growth],” says Sam Chandan, chief economist at Reis.

Another 73 million sq. ft. of new office space should be delivered in 2008. If that comes to fruition, that would represent the biggest annual pipeline of new supply since 81 million sq. ft. of office space was completed in 2002.

It's doubtful that the market will shrug off this deluge of new supply, say industry experts. Chandan expects rental rates to head on a downward trajectory through 2009. Average annual effective office rents are projected to increase by 6.2% and 4.6% respectively during the next two years, according to Reis.

Prospective buyers balk

Another indication of slower deal volume is the pace of overall commercial real estate mortgage originations, which dropped 4% in the third quarter versus the same period in 2006, reports the Washington, D.C.-based Mortgage Bankers Association.

The decline was even sharper for securitized loans. Loan originations in the commercial mortgage-backed securities (CMBS) market fell by 28% in the third quarter versus the same period a year ago. CMBS originations for office deals also posted a 31% decline.

The nation's largest banks continue to get hammered by bad subprime bets. In early November, for example, Citigroup booked $11 billion in losses tied to subprime debt.

Still smarting from write-downs, many banks like Citigroup have shied away from financing large-scale properties. Consequently, the volume of office investment sales could continue to weaken.

Indeed, sales of U.S. office buildings totaled $8.5 billion in September, down from an average of $11.5 billion in September of each of the previous two years, according to Real Capital Analytics.

Adding to concerns are declining property values. A late November report from Manhattan-based Moody's Investors Service found that commercial property values declined by 1.2% during September. Moody's bases its valuations on sales data rather than appraisals.

Impasse over asking rents

Until recently, office buyers relied on huge quantities of debt to finance their deals. In 2006, the average loan-to-value (LTV) ratio for an office building priced at $5 million and above was roughly 78%, up from 69% in 2005.

Chandan of Reis believes that many recent office buyers will resist lowering their asking rents because they are shouldering steep monthly mortgages. If their current cash flows aren't covering their debt service, they will be hamstrung to scale back asking rents.

The frenzied pace of deals in recent years reduced capitalization rates from 7.2% to 6.8% between the end of 2006 and September 2007. That downward trend was a lagging indicator of the lofty prices that investors paid to win deals.

“Many [of these] buyers assumed that they could increase cash flows at these properties by as much as 16% in 2007 and 2008,” Chandan says, “but in many cases it will take several years for the cash flows to hit those levels.”

Market distinctions

Bill Krouch, CEO of markets at Chicago-based real estate services giant Jones Lang LaSalle, is keeping a close eye on tenant demand. Many of the largest corporate tenants have adopted a wait-and-see stance on adding new space, he says.

“We certainly hear that corporate tenants are being more cautious right now about expansions,” says Krouch.

“Everyone wants to know how the credit problems will bleed through into office leasing demand,” he says. “The effect on office fundamentals will also depend on individual markets.”

Investors will need to be selective in 2008. The best performing markets will likely be coastal cities. Reis projects that New York, San Francisco and San Jose office landlords will post annual revenue growth north of 7.8% through 2011.

Adds Krouch: “We expect to see slower growth in secondary and tertiary office markets [in 2008].”