Fitch Sees Tough Year for Office Market

Among the difficulties that office REITs will face are a number that will affect all commercial property types: For example, the global credit crisis "has severely affected businesses in virtually all industries around the world and particularly in the US," the Fitch report points out. The ratings agency is projecting the steepest decline in GDP since World War II across the US, Europe, the UK and Japan. " This is of particular concern for the office sector, as space absorption is driven by growth in GDP and employment," Fitch points out.

The fallout from the US recession and the general global slowing has already caused many office tenants with upcoming lease expirations to renew their leases in existing space for shorter durations--often two to three years--compared with the longer deals that they would typically sign for in better times, Fitch observes. It adds that, although landlords generally prefer longer-term leases, most short-term leases signed today have little or no allowances for tenant improvements because property owners "remain fairly capital constrained." Instead, landlords are offering concessions such as free rent and other incentives.

The Fitch report contrasts conditions in the strongest and weakest US office markets, pointing out that the best markets have enjoyed much stronger fundamentals. "However, strength in the best markets, including many prime urban submarkets along the East and West Coasts, was largely driven by aggressive growth in financial services tenants and the companies that served them," the Fitch outlook notes. As a result, the top markets are weakening from job losses in financial services.

Fitch also contrasts the current office market downturn to the recession of the early 1990s. The biggest difference is that, this time, a glut of new supply is not the problem that it was in the early 90s. "Twenty years ago, there was severe overbuilding of office space due to a combination of aggressive lending and generous tax benefits for developers and investors," the Fitch report explains.

But in this cycle, new office development has been far more limited for a number of reasons. Office developers were generally outbid for sites by developers in other sectors, particularly residential, and construction costs have increased dramatically, making it even more difficult for office developers to build profitably.

The US office markets have already weakened, according to year-end reports now being issued by a number of brokerage and research firms. Fitch expects to see that trend continue as the year progresses, with rent declines and creeping vacancy rates in the office sector.