Sublease Space Reducing Effective Rents

However, these dynamics will create opportunities for credit-worthy tenants, the report states. Observes Greg O'Brien, Jones Lang LaSalle's CEO of brokerage, Americas: "If you're a creditworthy tenant with a good future business model, it's a great time to be in the marketplace as the actual net effective rate is much lower than asking rates."

In the fourth quarter of 2008, Jones Lang LaSalle research showed sublease space reached nearly 56.4 million square feet in 24 metropolitan markets. It forercasts that sublease space, which has climbed 28.5% since second quarter 2007 when the credit crisis began, will jump further in the coming months as corporate America's more recent job cuts trickle down to commercial real estate.

Layoffs didn't begin hitting the office market in a big way until the end of 2008 and there have been significant job losses in the first quarter of 2009, O'Brien points out. "The lion's share of sublease space will hit in the first six to eight months of 2009," he says.

In the fourth quarter of 2008, sublease space spiked nearly seven million square feet from the previous quarter. Another 40 million to 50 million square feet could come to market by midyear, according to JLL research. At the same time sublease space has increased, leasing volume has waned. Jones Lang LaSalle found all leasing activity in the US has dropped 43.9% since the second quarter of 2007. In the fourth quarter of 2008, leasing activity totaled 27.3 million square feet across markets tracked by Jones Lang LaSalle, a decrease of nearly 12.5 million square feet in three months or a 31.3% backslide.

The report states that increased sublease space and slower tenant demand have reduced the average overall office rental rate by 2.1% to $28.79 per square foot, while the average class A rate declined 1.7% to $32.14 per square foot during the last two quarters of 2008—reflecting the first market-wide rent drop in more than three years. The sublease impact on direct space will further erode office rental rates and result in higher tenant-improvement allowances and increased concessions, including more months of free rent.

Jones Lang LaSalle's sublease research showed West Palm Beach and Jacksonville, FL and Philadelphia already surpassed their peaks from the 2001-2004 downturn. The largest contributors of sublease space had been housing, construction, mortgage-related, finance and technology companies and law firms, however, in the fourth quarter, the report states, all industries had contributed to the increase.

Currently, average sublease rents are running 15% lower than direct rates, but greater discounts are likely as the year progresses, according to JLL. In the 2001-04 down cycle, sublease space was discounted an average of 22% from prime rents. During the fourth quarter of 2008, 18 of the 24 markets reported double-digit discounts on sublease space in comparison to direct space rates.

Along with the rise in sublease space has come an increase in free rent. Landlords in seven major metros now offer six months or more of free rent as signing incentives to undercut the competition, the JLL report points out.

Mike Ellis, managing director of agency lLeasing for Jones Lang LaSalle, says that although no markets are exempt from the current economy, "We do expect to see some pockets of growth in select sectors and markets." The stimulus package that was signed into law is expected to infiltrate into the economy in the second half of 2009, he says, and while this won't immediately have a direct impact on the commercial real estate industry, it is expected to infuse consumer spending in the second half of 2009 and create some residual growth in the commercial real estate sector in 2010.

The Washington, DC metropolitan area is expected to growth from the government sector over the next 12 months as agencies related to infrastructure, education, healthcare and financial regulation stimulate growth, Ellis says. On an industry level, the report shows that construction, sustainability services, education and healthcare are industries likely to grow and could help create some new demand in markets such as Austin, TX, Raleigh, NC, Pittsburgh, PA and Sacramento, CA.

Ellis comments that JLL expects the current dynamics to turn around in 2010. "Until then we are strongly encouraging our clients to aggressively retain the tenants they have," he says.