Reaping the rewards of rising rents and positive net absorption, office owners are in good spirits these days. Asking rents posted a 1.8% increase in the third quarter, but perhaps even more telling is that the gap between asking and effective rents is the tightest it's been in four years, according to real estate research firm Reis. The upshot is that landlords are offering fewer concessions to new tenants.

There's more good news: Office vacancy fell by 30 basis points during the third quarter to reach 13.5% at the end of September. That marked the 10th consecutive quarter of declining vacancy, down from 16.9% recorded near the bottom of the market in 2003.

Slowing economic drivers

Still, many market watchers fear that the office rally may be running out of juice. Their chief concern is that job growth will slow in 2007, which could limit demand for office space. Additionally, a spike in office completions could conspire against landlords' plans to boost rents.

“I think that 2006 will go down as a banner year, but next year is likely to see slower economic growth that's bound to seep into the office market,” predicts Sam Chandan, chief economist at Reis. Chandan believes that steep energy prices and a weakening housing market could hamper job growth in the coming year.

There are potentially troubling signs. During the third quarter, the economy grew at its weakest pace in three years. The 1.6% increase in gross domestic product (GDP), which measures total economic activity in the U.S., was less robust than in the second quarter when GDP was 2.6%. Furthermore, a significant amount of office space is under construction, clouding the near-term outlook.

Completions are expected to double in the fourth quarter. While roughly 8.9 million sq. ft. of new office supply was completed during each of the past three quarters, Chandan expects almost 20 million sq. ft. of new space to be completed this quarter. He also projects that 2006 will bring 46.4 million sq. ft. in new office space, up from roughly 37.2 million sq. ft. for the full year of 2005 (see chart).

When combined with a slower pace of net absorption, Chandan says that new supply could thwart the decline in vacancy that office investors have come to expect since the end of 2004. There already is some projected moderation in asking rents. Chandan expects asking rents to grow by 3.2% in 2007, well below the 6.1% uptick in 2006.

Another economic trend that Chandan is eying closely is merger and acquisition activity in Corporate America. With billions of dollars in mergers completed in the first 10 months of this year — including Blackstone's proposed takeover of the nation's largest office owner Equity Office Properties Trust for $20 billion in late November — merger-driven consolidation could limit demand for new space. Technological gains, which have already eliminated many staff positions, could further limit expansion plans.

Growth markets

So where should office investors place their bets in 2007? Coastal markets should lead the pack in rental growth next year, reports Property & Portfolio Research (PPR). The Boston-based real estate consulting firm projects that San Jose will post a 12.1% increase in effective rents over the next four quarters. San Francisco and Seattle will follow with expected gains of 9.5% and 9.2%, respectively. New York City office landlords will round out that list with 8.7% gains in effective rents.

While coastal cities have wracked up strong job gains in recent years, some lower-cost interior markets are also adding jobs at a decent clip. The Department of Labor reports that both Dallas and Chicago created more office-using jobs in 2005 than Los Angeles.

The Windy City, in particular, has some dynamic submarkets. In November, the Concourse Office Plaza in Skokie, Ill., sold for $39 million after trading hands for less than half that price — or $19 million — in 2003. Podco Concourse LLC, a private investment partnership, sold the 293,280 sq. ft. office complex to The Lionstone Group.

Three years ago, Podco Concourse bought the two-building complex as a value-added investment. At the time, the building was 49% leased and in need of a facelift. Following extensive renovation and an aggressive leasing campaign, Concourse Office Plaza is 75% leased.

“This building is in one of Chicago's strongest submarkets, and that appealed to the buyers,” says Randy Podolsky, principal of Podolsky Northstar CORFAC International, which served as the exclusive leasing, management and sale firm for Podco Concourse. “We accomplished what we set out to do at Concourse Office Plaza. It was a natural to orchestrate the timely disposition of the asset.”

Given the frothiness that in the investment sales market, experts say that value-added deals may present the best investment opportunities in the near term.