Office Market Braces as Vacancies Rise

Though most industries have been hit hard by the events of the past year and a half, many have not experienced the perfect storm that the office market …

Though most industries have been hit hard by the events of the past year and a half, many have not experienced the perfect storm that the office market has. Unemployment rates are rising, companies are folding and many who have survived the downturn are reducing their spatial needs. This is compounded by the fact that some industries—namely real estate, banking and finance—participated in a mass exodus from many of the nation’s biggest employment sectors once the market turned. Contending with all of this, landlords are in for a rough 2009.

According to Grubb & Ellis’ 2009 Global Real Estate Forecast, there was 90 million square feet of office space under construction at the end of 2008—a majority of which will be delivered this year. This will be added to the approximate 45 million square feet of negative absorption, causing the nationwide office vacancy rate to increase from 14.5 percent to 16.5 percent, the study predicts.

One Bright Spot

Nearly every office market in the nation will experience a tough 2009. There is, however, one market that offers office investors and landlords some promise.

“No one is going to escape the downturn unscathed in 2009—except Washington, D.C.,” said Robert Bach, senior vice president and chief economist at Grubb & Ellis.

According to Bach, the nation’s capitol is the best office investment opportunity on the market. This is because the credit crunch that is hurting the rest of the nation may actually buoy Washington, D.C.’s office market, as the government will need to hire significantly more people to create its economic recovery plan. More jobs will also be added if President-elect Obama has his way. On January 6 he urged Congress to create more than three million jobs in the next two years, including 600,000 new government jobs. Though not all of these jobs will be based in Washington, D.C., the district is sure to absorb a significant amount.

Strong population growth and natural barriers to entry also pushed a few other cities to the top of Grubb & Ellis’ list of top office markets. Portland, Oregon, Los Angeles, San Francisco, and Austin, Dallas-Fort Worth and Houston, Texas, rounded out the firm’s list, though Bach noted that Washington, D.C., is likely to be the only favorable market in 2009.

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The Holding Period

Despite high vacancies, most economists and financial advisors agree that this is not the year for landlords to make any sort of rash decisions about selling.

“It’s going to be more of a buy-and-hold market for the next few years,” Bach said. “I don’t think anybody is going to buy [office] properties, make money and then quickly turn them around in 2009. Those days are over for some time.”

Even though the prospect of making money in the office market is pretty bleak, it does not mean that unloading that currently unprofitable property is a good idea, either. “Don’t sell unless you have to,” Bach advised. “It’s never a good idea to be a forced seller. In 2009, buyers are going to have the upper hand and negotiation leverage.”

Instead, entering into a holding period, if at all possible, seems to be the action of choice. Even as some owners may find themselves with lost revenue due to unoccupied space, Bach noted that others may beat the recession altogether if neither their loans, nor their tenants’ leases expire within the next three years.

For those who do have leases coming due, the fierce competition among office owners may force some landlords to offer concessions and even tenant improvements to maintain occupancies.

Discounts and breaks in rent are extremely popular with tenants today, as many companies are scraping to get by. Locking in a discounted rental rate for the next five years can make all the difference between a company renewing a lease or moving into the new building down the street. Depending on how long a landlord can hold, a renewed lease at a discounted price should extend for two to five years. Another popular concession is free rent. In a normal market, a landlord may offer a month’s worth of free rent for every five years a tenant resides in the building. In a down market, however, many landlords are agreeing to forego that monthly rent once every year.

Be Proactive, Not Panicked

When the market shifts and the power rests in the hands of the tenants, there’s no question that landlords must do what they can to entice new clientele and renew the faith of their current tenants. There are times, however, when intense market competition can push owners into giving up too much. This often happens with tenant improvements. By offering concessions, landlords are simply losing out on future income that was never guaranteed to begin with. But with tenant improvements, that money is coming directly out of the landlord’s wallet. Bach noted that approximately $20 per square foot is the standard rate for tenant improvements, but the market has seen this number double and even triple in some regions, especially in the large metropolitan areas that have seen the implosion of entire industries.

Putting all the cards on the table can result in astronomical tenant improvement fees, not to mention renewed leases that could be well below market value once the economy recovers. Acting out of fear or panic, Bach noted, is what spurs a recession in the first place. “Look at the retail market,” he said. “Consumers stopped spending, decided to hunker down and saved more. That was a smart decision on a household-by-household basis, but when you multiply that by most of the houses in the country you get a recession.”

The same can be said of the office market: owners compete for tenants and, in the spirit of competition, continue to make their spaces more and more desirable until they are no longer profitable and tenants can all but steal away any prime locations they want.

“Landlords get nervous—they read the headlines, they get spooked,” Bach continued. “Even in relatively stable markets we’re seeing a change in psychology. The decisions that [landlords] are making to trade rent for occupancy might be putting more bargaining power into the hands of tenants than might otherwise be the case. Market conditions don’t necessarily warrant the level of landlord incentives, but they are anticipating that the worst times are to come, so there is a level of panic among landlords.”

Instead of killing their bottom line, Bach believed that proper management, combined with some research into an area’s emerging industries, could get landlords through this tough time. For example, instead of continuing to court businesses within the real estate and financial sectors, Orange County office owners could research the growing needs of technology and biotechnology firms, two industries that are gaining momentum in the area. This doesn’t necessarily mean converting one’s office space into laboratory facilities, but rather conducting the necessary due diligence to see what needs the current business community has and how an office property can accommodate those needs.

Clearly, 2009 is not predicted to be a profitable year for many industries, office properties included. Though there is no golden strategy to escaping this recession unscathed, there are many tactics that landlords can employ to minimize losses and ensure that they’re in the best possible positions when the market recovers and the chips are back in their corner.


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