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Blackacre Advisors: representing tenants in leasing commercial office space

Innovative representation of tenants in leasing commercial office space

Market trends

As the U.S. economy cools, in the wake of the credit crisis and waning business confidence, leasing activity slows across most markets nationally. 4th Quarter 2007 marked the first time in the past 16 quarters that the national office vacancy rate increased. Unless the economy shakes its cold, the overall outlook is for weak office space demand resulting in vacancy rates to edge up while rents will remain flat and, some markets, decrease. In office markets where the economy is strongly tied to the mortgage industry and residential real estate market (e.g, Tampa, San Diego, Orange County), we are witnessing a more dramatic slow down in leasing activity. In a handful of cities (e.g., Boston, New York City, Seattle), however, rents continue to rise and vacancy rates fall.

Given the direct correlation between job growth and office demand, a recession would accelerate the increase in vacancy rates and decrease in rents. New construction has been limited so any major downturn would not have a lasting effect.

With the recent massive sales of office buildings at record prices, the new landlords will continue to try to push rents to meet their pro forma. Some markets, however, will not allow for such rent increases.

Unlike the residential real estate market, the credit market crisis impact to the overall office market has been more benign, but still a definite factor. First, the increased cost of financing will slow the sale of buildings down. Second, higher financing costs will push down property values since buyers have to pay less to maintain their return on investment. Third, stricter loan underwriting criteria will slow down building sales and it will put a brake on new construction.

In evaluating their office leasing options, tenants are increasingly weighing the environmental impact. In addition to the social considerations, with soaring energy costs, tenants and landlords are recognizing the economic benefit of “green” buildings. This is a trend that will continue to gain momentum.

Chicago Office Market

New York City Office Market

South Florida Office Market

Central Florida Office Market

The Chicago metropolitan office market is the “Tale of Two Cities”. The CBD is very strong while most suburban markets are weakening after having improved over the past couple years. The CBD’s vacancy rate is at the lowest point in 5 years driven by strong leasing activity by professional service firms. At year-end 2007, the overall vacancy rate was 11.5% compared to 13.8% at year-end 2006. The goods times for CBD landlords may be short lived. Unless demand continues, with several new buildings delivering in 2009 – 2012, the CBD office market pendulum will swing back to tenants. The CBD’s average quoted Class “A” rent is $34/sf and $26/sf in Class “B” spaces.

Until 2006 the Chicago metropolitan area trailed the national average office employment growth. For the past two years, however, the local office employment growth – while declining - has exceeded the national average which is also in decline.

Tenants have the leverage in the suburban markets, less so in the Northern Corridor. Over the past year, leasing activity has slowed down. Particularly hard hit have been the northwest suburbs (and to a lesser extent the west suburbs) where many mortgage companies where located. New construction has been limited and a couple spec buildings are struggling to find tenants. The Northern Corridor, by contrast, has performed very well and is expected to in the future given the underlying fundamentals and a economy tied to the healthcare industry (see Abbott Labs, Baxter, etc.). Given the constrained geography of the O’Hare Airport office submarket which has always been an inherent constraint on new construction, investors are betting that this submarket will return to its peak in the “dot com” era when the vacancy rate was in the single digits. The overall suburban average quoted Class “A” rent is $23/sf and $19/sf in Class “B” spaces.

While leasing activity has slowed, the New York City office market remains strong given its diverse economy and underlying fundamentals. For the past 10 years, the average vacancy rate for all office classes is 7%. In 2008, albeit at a slower pace, rents will continue to rise and vacancy rates continue their downward trend. At year-end 2007, the overall vacancy rate was 5.3% compared to 6.2% in 2006. A major space disposition by banks, in light of the current financial crisis, would be welcome relief for tenants.

As tenant confidence in the economy wanes, fewer tenants are “banking” space for future growth which was a common practice over the past few years. This is one of the main reasons for the drop in leasing activity.

Overall average quoted rents for Class “A” space is $74/sf and $52/sf for Class “B” space. Midtown rents, in some trophy buildings exceeding $150/sf, continue to push tenants south to Midtown South and Downtown as well to consider Westchester County, New Jersey and Connecticut. With this southern migration, Downtown vacancy rates are low and rents are high. Tenants searching Downtown will have a limited number of quality options. As a result, renewal will be given great consideration by many Manhattan tenants.

The major residential real estate meltdown in South Florida has spilled over into the office sector. The year-end vacancy rate for all office classes across the tri-county area (Dade, Broward and Palm Beach) was 9.9%, whereas in 2006 it was 7.6%. As office employment drives the office space demand, from 2003 through 2006, South Florida exceeded the national average. By contrast, in 2007, the office employment growth was below the national average.

Asking rents across the tri-county area have been flat. In Class “A” office buildings the average asking rent is $32/sf in Palm Beach County, $30/sf in Broward County, and $37/sf in Dade County. In Class “B” office buildings the average asking rent is $26/sf in Palm Beach County, $24/sf in Broward County, and $27/sf in Dade County.

In pursuit of higher ROI’s, many developers were building new residential and retail developments over the past few years. As a result, office development has been limited. With limited areas for new construction, fundamentals remain solid in the office market. Rising insurance costs and real estate taxes continue to be a major factor. Tenants facing renewals are seeing landlords, guarding against rising insurance costs and real estate taxes, convert their gross leases to net leases.

As in South Florida, the residential real estate and credit market crisis is weighing down on the office markets in Central Florida. In Orlando, 2007 leasing activity was weak relative to that in 2005 and 2006. For all office classes, the net absorption (the amount of space leased after deducting the amount of space vacated in the same period) in 2007 was 420,000 sf whereas in 2006 it was 2.95 msf and in 2005 it was 3.3 msf. The positive news is that Orlando’s office employment growth is tracking ahead of the national average. Additionally, the overall vacancy rate remains low at 9.4% as of year-end 2007 which is an increase of from 7.8% as of year end 2006. The Orlando Outlook is status quo where the average quoted Class “A” rent is $25/sf and Class “B” rent is $21/sf.

East on I-4 to Tampa, leasing activity was equally weak in 2007. The Tampa office market which includes the St. Petersburg and Tampa Airport Westshore market is twice the size of Orlando’s office market. For all office classes, the net absorption in 2007 was 1.6 msf where 1.3 msf was leased in 1st Quarter 2007. In 2006 net absorption was 2.8 msf and in 2005 it was 3.2 msf. Nonetheless the overall vacancy rate remains low at 9.4% as of year-end 2007 which is an increase from 8.7% as of year-end 2006. The amount of space being market for sublet spiked in 2007 given the large presence of mortgage lenders in the Tampa area. Tampa’s office employment growth has been tracking below the national average. The average quoted Class “A” rent is $24/sf (while rents in newer buildings in the popular Westshore submarket exceed $30/sf) and Class “B” rent is $21/sf. The Tampa Office Market Outlook includes rising vacancy rates (particularly as another 1 msf of new construction will delivery in 2008) and flat to decreasing rents.

*The information contained herein was gathered by Blackacre Advisors LLC from CoStar, property representatives, and other sources believed to be reliable. Blackacre Advisors LLC, however, makes no representation concerning the accuracy or completeness of such information and expressly disclaims any responsibility for inaccuracy herein.