After hotels, the office sector is the biggest victim of the soft economy, according to Chicago-based research firm Real Estate Research Corp. (RERC). And unlike the retail, industrial and multifamily sectors, experts predict that office fundamentals will continue to crumble before improvement begins some time in 2004.

The national office vacancy rate registered between 14.4% and 16.8% in the third quarter of 2002, based on estimates by CB Richard Ellis, Cushman & Wakefield and Grubb & Ellis. A year ago, the same brokerages reported national vacancies between 10.6% and 13%.

“Vacancies are going to continue to rise,” predicts Jay Spivey, director of analytics for Bethesda, Md.-based CoStar Group Inc. “Unfortunately, we're still seeing quite a bit of negative absorption, combined with new space being delivered to the market, both of which are continuing to push up the vacancy rate.”

In a worst-case scenario, vacancies could approach 20% when non-central business district and sublease space is factored in, warns New York-based Lend Lease Real Estate Investments and PricewaterhouseCoopers in their joint survey “Emerging Trends in Real Estate: 2003.” As one survey respondent wrote, “All my clients have too much space. It is impossible to justify any rental growth in any office market next year.”

The Flood of Sublease Space

The main cause of the vacancy problem is an unprecedented overhang of sublease space. “When the tech bubble burst, tenants ended up with more space than they needed because they had to do something to stop the bleeding,” explains Steve Goldstein, senior executive vice president of New York-based Julien J. Studley Inc. “So the subleasing market has become the rule rather than the exception.”

Sublease space skyrocketed from 92.6 million sq. ft. in the third quarter of 2001 to 122.7 million sq. ft. in the third quarter of 2002, reports Cushman & Wakefield.

The New York-based firm predicts that markets dependent on the financial services sector — such as New York — will find it difficult to reduce the glut of sublease space as financial services firms continue to downsize.

The flood of sublease space also has landlords casting a cynical eye on prospective tenants, says Maria Sicola, senior managing director of research for Cushman & Wakefield. “Landlords looking to lease space in large blocks are going to look an awful lot at the tenant's ability to pay the rent going forward,” she says.

One positive trend is the slowing rate of construction, says Spivey. At mid-year 2001, there was 167.4 million sq. ft of space under construction, which dropped to 77 million sq. ft. in the third quarter of this year.

However, there's still far too much capacity. Year-to-date negative absorption in the third quarter stood at 24.4 million sq. ft., up from 23 million sq. ft. in the third quarter of 2001, according to CoStar.

Rents continue to weaken as concessions become more common in the office market. Cushman & Wakefield reports that rental rates in CBDs averaged $30.50 in the third quarter of 2002, down from $32.24 in the third quarter of 2001.

The Silver Lining

One bright spot in the otherwise gloomy forecast is the sales market, which is expected to remain robust. But buyers are being choosy, says Goldstein. U.S. investors looking for long-term returns are purchasing properties occupied by high-credit tenants with long-term leases.

Case in point: Atlanta-based REIT Wells Real Estate Investment Funds acquired a pair of Class-A office buildings in Washington, D.C., for $345 million, its single largest property acquisition to date. Independence Square I and II, which total 949,000 sq. ft., are both occupied by government agencies with leases running through 2012. “This property is a great asset in every sense,” says David Steinwedell, chief investment officer for Wells.

Domestic and international investors are targeting real estate because alternatives, such as the stock market, are doing so poorly, Goldstein says. Although real estate fundamentals are deteriorating, investors are “prepared to take lower returns because they are greater than any other return in any other vehicle,” he adds.

According to New York-based Real Capital Analytics, October was the sixth consecutive month in which more than 100 buildings valued at greater than $5 million changed hands, with investors buying more than $3.4 billion worth of properties.

Despite the heated sales market, the office sector as a whole is in for a period of retrenchment in 2003, as downsizing corporations continue to shed excess space in response to the uncertain economy.

“It's paramount for the office sector in particular to see job growth,” emphasizes Ken Riggs, CEO of RERC, “in order to start seeing some demand and to get some of this space absorbed.”