Extra! Extra! Read all about it! It’s nearly impossible to skim metropolitan newspapers these days and not glimpse a headline foretelling the glum rate of commercial office vacancies. While the news is difficult to swallow and projections for a rebound in business confidence seem far off, there is a brighter side to all the gloom and doom.The national average vacancy rate for commercial office properties at the end of fourth quarter 2002 was between 15 and 16 percent, well above the low rates witnessed during the height of the New Economy. “Vacancy in most markets was at or under 10 percent when the market was at its peak in early/mid 2001. Vacancy rates have risen steadily since then,” says Stephen Schlegel, chief operating officer, Leasing and Management, Jones Lang LaSalle Americas Inc., New York City. Some markets are healthier than others, but on average, central business districts (CBDs) are weathering the stormy economic conditions better than suburban markets. “The suburban vacancy rate is 18.9 percent. The central business districts have held up better, but they are by no means immune, either,” reports Robert Bach, national director, Market Analysis, Grubb & Ellis Co., Northbrook, IL. Experts have speculated that the ease of building in suburban markets has created more supply, increasing the impact of weakened demand.While no market has remained unaffected, the Washington, D.C. area has maintained the strongest performance. Even Emerging Trends in Real Estate 2003, a report produced annually by PricewaterhouseCoopers LLP and Lend Lease Real Estate Investments Inc., cites D.C. as the top market in the United States, stating, “No matter whether Republicans or Democrats control the power corridors, government keeps leasing space and lobbyists seem to multiply.” According to Schlegel, “Rents have held up there and vacancy is plus or minus 10 percent.” New York City’s Midtown, Los Angeles, San Diego, and Chicago complete the list of Emerging Trends’ top five markets. Influencing FactorsThe two-word answer to why vacancy rates have escalated to this point is simply, “the economy.” Companies’ actions and reactions to a strong market, and then more recently a weakened economy, are factors in the “why” question of how vacancies have risen so high. Corporate downsizing and lack of job growth. With companies tightening budgets and scrutinizing spending, corporate lay-offs have created a vast amount of available space. The worst job losses since the months following Sept. 11, 2001, were reported for February by the government. “Companies in this cycle have been a lot quicker to lay people off and throw space on the sublease market or simply not renew than they were 10 years ago when the economy and the market was in the last cycle,” Bach says.The amount of sublease space on the market. While everyone agrees that sublease space is not the cause of high vacancy rates, it has added to the inventory of available suites. “Historically, disposition space/sublease space is something in the range of 10 percent of the total inventory of space that is available, and across the country today that number is more like 25 percent,” Schlegel explains. Speculative leasing prior to the economic depression. Long before anyone was predicting an economic downturn, companies were experiencing rapid growth and business success. As far as the eye could see, the prospect for the future was positive. “When the economy was rolling, companies were leasing quite a bit more space than they needed in anticipation of continued, rapid growth. They were inventorying additional office space. When the bubble burst, it significantly increased the impact,” says David K. Reed, senior vice president, Development/ Marketing, Lincoln Property Co., Dallas. Companies were leasing space for the future and locking in on rates they thought were only headed in one direction – up. Much of this space is now on the market and available for sublease.Markets that weren’t diversified have suffered. When the fall of the dotcoms occurred, the domino effect it had on real estate was nowhere more evident than in the cities that gave birth to the phenomenon. Markets like San Francisco, San Jose, Dallas, and Atlanta suffered significantly because of heavy reliance on leases from high-tech companies. “Any market that is heavily dependent on a single industry will see profound consequences on real estate when that industry has a significant downturn,” Schlegel notes. Evidence of this is the high vacancy rate in the Dallas/Ft. Worth area. As of the end of 2002, the two were running between 25 and 30 percent.Reluctance to sign new leases. Among predictions that the war in Iraq would not be as swift as originally planned, the lack of business confidence has resulted in some hesitancy to finalize lease agreements. According to Schlegel, “The pace of decisions has become much more protracted than when the market was hot. Any significant real estate decision that has financial consequences on a firm tends to be evaluated over much longer periods of time and occasionally goes away after awhile.” Comparing this RecessionReal estate recessions in the last few decades have typically been the result of an overbuilt marketplace. While the suburban markets can truthfully use this excuse to rationalize their high vacancies, overbuilding is not the prevailing cause of the current recession. “The CBDs in the late ’80s had a lot of speculative construction and then when the recession hit in the early ’90s, vacancy rates were much higher than they are now,” says James Delmonte, assistant director of Research, Cushman & Wakefield, New York City. Delmonte attributes today’s less significant vacancy rate to the frequency of pre-leasing activity in CBDs during recent years. Historically, past recessions showed spotty market conditions, whereas the current recession has spawned an across-the-board condition of malaise. “I think 10 years ago, you could legitimately point to certain markets and say, ‘These are holding up well – there is still positive net absorption and demand is good,’” Bach explains. All signs seem to indicate that rather than being a reaction to overbuilding, the current real estate situation is the direct result of a weakened economy that has resulted in diminished demand. The Silver LiningDespite all this bad news, there are some positive aspects to the current situation. For those companies surviving and even thriving, now is the ideal time to lease space. “I think the general consensus is in more major markets, the heated activity of the late ’90s and early 2000s probably inflated rates a bit past equilibrium,” assesses Schlegel. This market correction has proved favorable for companies looking to lease, especially in areas where dotcom hunger for space drove rental rates to a point of over-inflation. According to Delmonte, “If you look at areas like San Francisco that were very much into the high-tech sector, you’re seeing asking rents come down by as much as 50 percent.” With so much sublease space available, landlords are competing with their own tenants for companies interested in leasing. To remain competitive, rental rates are dropping and additional incentives are being offered. According to Emerging Trends, “Rents in many markets have backed off their late-’90s spikes entirely and then some. In some markets, concessions have returned, including free rent and lavish tenant allowances.” Among the truly aggressive landlords, moving and lavish tenant improvement allowances, assuming the remaining lease on a tenant’s old space, furniture, or free rent upfront are packaged in to lease agreements with the hope to convince the weary. Landlords are also offering tighter building security to set minds at ease in this post Sept. 11, 2001, era.With rates contracting, there is an opportunity to lease space that may have previously been too expensive. Tenants can move up the value chain, a process often referred to as a “flight to quality,” moving into more desirable properties or from the suburbs to the city. “Class B and Class C tenants have found that they can get Class A space with a much reduced rate,” says Bach.It’s also a good time to renew leases. “We are seeing a lot of renewal activity because of the rents – we may have reached the bottom so now is the time to renew before they start up-swinging again,” Delmonte advises.“For those types of strong tenants that are confident about their future earnings potential and their business plan,” says Bach, “now is a pretty good time to go out there and try to secure space for a build-to-suit.” Because the stock market has been volatile, commercial real estate has attracted the eye of many investors. “The silver lining is clearly the investment market where there has been a flood of investors looking to buy office properties – particularly properties that are Class A and have little roll-over risk over the next few years,” explains Bach. For landlords, the lower rental rates they have been forced to offer have been offset by lower interest rates. According to Bach, “Interest rates are so low now that owners have been refinancing and are able to save on their principal and interest payments, even as they lose some tenants out of their buildings.” This sentiment was echoed by Jeffrey S. Weil, senior vice president, Colliers International, Walnut Creek, CA, in his April 2003 Corporate Office Perspectives e-mail newsletter: “Low interest rates are doubly beneficial to commercial real estate. In the first instance, they help get the economy moving more rapidly, which spurs demand for properties. In the second place, they allow owners of commercial properties to refinance at a lower cost. This improves cash flow, sometimes dramatically.”With so much of the harsh reality being reported, it can be difficult to read between the lines. Despite projections by those who are optimistic (estimating vacancy rates will begin dropping slowly in mid-2003), most note that the recovery will not occur on any significant scale until 2004. However, it’s notable that this recession has not witnessed the numbers of foreclosures and delinquencies common during past real estate cycles. According to Ward S. Caswell, director of Information Management, CB Richard Ellis, Boston, “For the most part, the real estate owners managed to maintain their cash flows during this part of the cycle and we do appear to have the worst behind us in terms of the large quarter after quarter negative net absorption.”Jana J. Madsen ([email protected]) is senior editor at Buildings magazine.To view the vacancy rates in major metropolitan areas reported by REIS Inc., visit Buildings’ website at (www.buildings.com/realestate).