With the financial services sector in upheaval, the New York office market is beginning to feel the heat. And it is likely to get worse before it gets better.

Employment is the most important driver for commercial real estate, and the 159,000 non-farm jobs lost in September indicate an economy in recession by any standards, according to Ken McCarthy, managing director of research for New York-based brokerage Cushman & Wakefield. Speaking at a third-quarter market briefing in New York, McCarthy said the losses indicate “we are in the early stages of a downturn that will go on into next year.”

In the financial sector, after peaking in March, 10,000 financial services jobs were lost through August, and McCarthy expects further decline in the months ahead. However, job losses in financial services might be mitigated somewhat if former executives from the major investment banks begin to startup smaller, boutique firms.

The financial services sector has traditionally leased about 33% of the New York office space. This figure is now down to 30%, though advertising agencies have picked up some of the slack, according to Cushman. For instance, in one major deal this year, the advertising agency Ogilvy & Mather entered into a deal to take up more than 500,000 sq. ft. of midtown space, to consolidate its New York operations.

Vacancy in the New York office market rose to 7.4% at the end of the third quarter, up from 5.7% a year ago, leaving more leeway for tenants to negotiate, according to Joseph Harbert, COO for the brokerage firm’s New York metro region.

A vacancy rate in the range of 7% to 9% is one in which equilibrium is maintained in terms of the balance of negotiating power between landlords and tenants. And the vacancy is now heading toward levels at which tenants are likely to have the upper hand, Harbert noted.

Cushman expects rents to decline 10% by the end of 2009 as New York office vacancy climbs closer to 10%. In the early ’90s recession, rents were down 15% to 20% over a three-year period from the peak of the cycle to the trough.

“We believe we hit the inflection point of the market in August,” according to Harbert. “The top of the market was reached and now we’re beginning to soften. We’re coming down from historic highs, but the question remains how far we will fall.”

Harbert said that more space was put back on the market in the third quarter than the amount taken off the market. Negative absorption accelerated for New York in the third quarter to negative 2.9 million sq. ft. from negative 468,000 sq. ft. in the third quarter of 2007.

Meanwhile, sublease space skyrocketed to 6.5 million sq. ft. at the end of the third quarter, a 72% rise from 3.8 million sq. ft. at the end of last September.

In what seems like a counterintuitive result, as vacancy has been creeping up, asking rents have also risen in the third quarter. For the market overall, third-quarter asking rents were north of $72, compared with more than $62 in the third quarter of 2007. Asking rents stood at about $67 in the first quarter.

Besides the much-trotted out explanation that this is essentially a supply-constrained market, there’s another factor behind the rising rents. While asking rents are holding up, there is typically a 5% to 7% discount when it comes to the actual rents paid by tenants, or the effective rents, Harbert pointed out.

He sees net effective rents heading down. Asking rents are more of a lagging indicator that will react to the economy rather than be ahead of it. “Taking rents are down, asking rents will follow,” he said.

In terms of investment sales, the tightening availability of credit has caused total volume for transactions with a sales price greater than $10 million to fall 55% to $18.7 million from the third quarter of 2007, a level not seen since 2004.

Foreign investors have been the most active group of investors so far this year, accounting for about 40% of the sales closed. This group has spent $7.4 billion on Manhattan properties, compared with $5 billion at the end of last September.

A lot of capital has been raised and is sitting on the sidelines and waiting to seize opportunities, according to Harbert. The stumbling block is that there is a disparity between the prices buyers and sellers are seeking.

As for the outlook, Harbert expects that when the credit crisis is past, there will not be enough office space to go around, considering that there is not much new construction in the works, causing this market to regain any luster it might lose.