With the national office vacancy rate threatening to breach 17% by year's end and a wave of maturing loans coming due, landlords are working feverishly to clean up their balance sheets and retain tenants.

At this juncture a year ago, owners believed that they would be able to weather the downturn by granting higher tenant improvement allowances and free short term rent, rather than lowering rents. That scenario never played out.

In the first quarter, the U.S. office vacancy rate climbed to 15.3%, up from a low of 12.5% in the third quarter of 2007. Over the same period, effective rents fell by 3.6%. And by year's end, Reis projects effective rents will shrink by 8.1%.

“In 2008 I think most people in the industry were feeling like we were headed into a recession in the first part of the year. But I think everybody felt like it was going to be relatively manageable,” says Charlie Baughn, CEO of the capital markets group at Hines.

The optimism appeared well-founded. In June 2008, the unemployment rate was 5.6%, and the office market was showing only modest signs of weakness with negative net absorption of 3.8 million sq. ft. in the second quarter. By June 2009, the jobless rate had climbed to 9.5%. Meanwhile, negative net absorption had ballooned to 20 million sq. ft. in the second quarter.

“No one really anticipated the depth and magnitude of how this downturn would affect specific firms,” says Victor Calanog, chief economist for research firm Reis. “It wasn't like tenants were just downsizing in space, it was like they were going out of business altogether.”

World without debt

Today's office owners and developers must also navigate an extremely illiquid marketplace. Maturing debt and a severe drop in property valuations will further compound the problem.

According to Moody's Property Price Index, asset values in the U.S. had fallen 29.5% through April from their peak in October 2007. Many owners now have mortgages that are underwater because of rising loan-to-values.

“The one thing that has saved everybody is the fact that LIBOR (London Interbank Offered Rate) is so low,” says Baughn. “Everybody has these floating-rate loans that are priced off LIBOR, so a lot of property owners today are paying 1%, 2% or 3% on their mortgages.”

As long as owners are able to cover their debt-service payments, even if they're upside down on their mortgages, lenders are granting short-term loan extensions, says Baughn. Though a temporary relief, the practice is worrisome.

“There's a mountain of debt maturing in 2011 and 2012, and all we're doing is making the mountain bigger by pushing more loan maturities out to that same period,” says Baughn. Commercial real estate mortgage maturities for 2011 and 2012 combined total $602.4 billion.

Little to celebrate

With little capital available, transaction volume for office deals of $2 million and above slowed to a crawl, down 63% year-over-year at the end of the first quarter, reports Reis. And while distress opportunities in the office sector have been hyped in the news, like the sale of the Hancock Tower in March at a 50% discount, few Cinderella deals have actually materialized, notes Baughn.

In addition, the lack of demand has resulted in a shrinking development pipeline. “We did have several projects around the country that were pretty far down the road that we've mothballed in one fashion or another,” says Baughn.

The volume of new office completions has tapered off from 61.8 million sq. ft. in 2008 to a projected 53 million sq. ft. this year. In 2010, completions are expected to drop by 44% to 29.7 million sq. ft.

Despite so much disheartening news, the office sector is not without its bright spots. For instance, energy markets such as Houston and Fort Worth are still experiencing positive rent growth, while the growth of government has helped to keep rents stable in the nation's capital.

“But I don't think 2009 is a year that's going to have a lot of bright spots,” warns Baughn. “I think maybe we'll start to see some positive news next year.”