How Long Will The Tenant's Market Last?
It's that time in the economic cycle where the lagging nature of the commercial real estate market becomes more visible than the North Star. The economy looks and feels like it has emerged from the recession with expected moderate growth in the first half of 2002, but employment remains a lagging indicator. Companies have been reluctant to hire until they have a few good months of increasing orders under their belts and are confident that their new business can be sustained. That presents a real timing problem for building owners. Unfortunately demand for commercial real estate, particularly office space, depends on employment growth. The conundrum is that while employment growth is a lagging indictor of economic expansion, it is a leading indicator of real estate leasing activity and net absorption. You could say that real estate is a double lagging indicator of economic expansion. Another problem is that it takes a while for the real estate construction pipeline to empty. While most sectors of the economy were busy working off excess inventories during 2001, the construction pipeline added 81 million sf of competitive (multi- and single-tenant) office space and 123 million sf of industrial space--projects that were begun pre-recession. So, clearly the recession and the double-lagging nature of commercial real estate have combined to make a classic tenant's market in most areas and for most property types. The question is: How long will the window of opportunity be open for savvy tenants to maximize their leasing strategy? The answer is different for the office and industrial markets. A typical industrial warehouse requires six to nine months to construct, which means that the 57 million sf of space still in the pipeline should be substantially completed by mid-year. Conditions also look rosy for industrial space on the demand side of the supply/demand equation. The manufacturing sector of the economy is starting to pick up after a 19-month swoon, with inventories low, new orders high and production increasing. Retail sales are rising from last-year's recession-influenced levels as well. With manufacturing activity and retail sales both gaining momentum, there will be more goods and materials in all stages of the production process flowing through the nation's supply chains, boosting demand for industrial space. Tenants can make their best deals in the next three months or so. After that, the negotiating advantage will shift toward owners, thanks to rising demand and falling supply of space. Owners are courting industrial tenants of all sizes, seeking to match tenant size requirements with the dimensions and configurations of the buildings they are trying to fill. Small tenants are about as likely as large tenants to leverage rent concessions if they fit the profile targeted by the building owner. Looking at the office market, about two-thirds of the 72 million sf currently under construction is scheduled for completion by year end. Office leasing will be very slow to pick up, tied as it is to employment growth. The year-end 2002 office vacancy rate is likely to peak above 16%, more than six points above the generally recognized equilibrium level of 10%. With more space coming on the market this year and leasing activity expected to be slow, tenants will maintain their negotiating advantage through the end of the year. The market may tighten next year, but it will take a while for it to absorb the new construction added to the market in 2001 and 2002 plus the re-let space that was returned to the market via subleases or leases that simply were not renewed. Tenants can expect to make their best deals this year, with terms gradually tightening along with the market in 2003 and 2004. We're unlikely to see the return of a true owner's market with broadly rising rents and limited selections of space until 2005 at the earliest. Large office tenants are able to leverage more concessions, although this varies by market. In a very few locales, including some markets with a surplus of space, building owners are refusing concessions to small tenants. This seems to be a matter of local convention and the logistical and cost issues of dividing larger spaces.
To contact Robert Bach, email Bob.Bach@Grubb-Ellis.com |