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Commercial real estate has been through a ringer. We have survived the bursting of the dot-com bubble, the recession of 2001, the aftermath of Sept. 11, the jobless recovery of 2002 and the war with Iraq. With SARS looking as if it might be controllable, commercial real estate markets are– fingers crossed–set to embark on a more tranquil period. What can we look forward to over the next few years?

It would be reasonable to expect the office market to have deteriorated further during the first quarter in light of the economic weakness leading up to the war. That is what happened, but not to the extent one might expect.

The national vacancy rate rose to 17.6% in the first quarter, up 22 basis points from the beginning of the year. The rate of increase was less than one-quarter of the average increase during 2001 and 2002, when vacancy rose by 106 basis points per quarter. Central business district markets appear to be stabilizing. The CBD vacancy for all classes of space was unchanged at 14.6%, while CBD class A vacancy fell to 13.2% from 13.4% at the beginning of the year. Suburban vacancies continued to rise, ending the quarter at 19.3%for all classes of space and 20.7% for class A space.

Vacancy fell by a percentage point or more during the first quarter in Cleveland, Orange County, Kansas City, Seattle and Richmond. At the other extreme, markets posting vacancy increases of a percentage point or more include Omaha, Atlanta, Denver, Tampa, Cincinnati, Philadelphia and Sacramento. Markets posting the lowest overall vacancy rates are New York City; Oakland; Washington, DC; Riverside-San Bernardino, CA; and Nashville. Markets posting the highest rates include Dallas, San Francisco, Oklahoma City, Austin and New Jersey.

Several indicators suggest that the market is approaching the bottom. Just 41 million sf remain in the construction pipeline, down from 51 million at year-end 2002. Available sublease space fell to 136 million feet from 140 million at year-end, thanks to a combination of leasing activity and lease expirations. Although the level of sublease space remains severely elevated, it is at its lowest point since Q4 of 2001.

Asking rental rates for class A space were flat for the quarter, while B rents actually rose slightly. This probably is a one-quarter aberration because other indicators remain quite soft, and rents are usually the last indicator to become firm.

On the demand side, the market posted its ninth consecutive quarter of negative net absorption, but just barely. Absorption for the quarter totaled -617,000 sf compared to -10 million sf in the last quarter of ’02. Class A absorption was positive for only the second time in the past two years. The negative net-absorption numbers signal a decline in leasing activity, but by no means has it come to a halt. Grubb & Ellis tracked a sample of 64 million sf of lease comparables during 2002. Professional, scientific and technical services firms represented 28% of the tenants leasing space last year followed by finance and insurance tenants with 25% of the total. Technology companies, which cut across the three broad industry categories of information; manufacturing; and professional, scientific and technical services, leased 8 million sf in 2002, down from 29 million in 2000.

Despite the slightly more optimistic tone of the office market in the first quarter, the slide most likely is not over yet. The total number of jobs in the US has declined in six of the past eight months through April, and unemployment claims have risen alarmingly. This puts the economy at the doorstep of another recession (or a continuation of the 2001 recession depending on how the National Bureau of Economic Research defines the business cycle).

The improved tenor of other indicators since the war, such as consumer confidence and the stock market, could keep the economy from crossing that threshold. Look for the office market to slog through the remainder of this year with vacancy peaking around 18% by year-end. The vacancy rate should decline by two percentage points per year beginning in 2004, which would return the market to equilibrium at year-end 2007.

The industrial market ended the first quarter at 9.6% vacant compared to 9.5% at year-end 2002. Although vacancy continues to increase, the rate of increase has declined from the past two years. Industrial usually is the first to recover because (a) it does not get as overbuilt as the office market, and (b) demand for space does not depend upon job growth (a lagging economic indicator). Demand for industrial space hinges on a number of variables related to manufacturing including inventories, durable goods orders, production, wholesale trade and retail sales. The bad news is that manufacturing has been lagging since the summer of 2000, and it continues to struggle. This suggests that the industrial market, while not deteriorating much further, is unlikely to begin a sustained recovery before late this year or early 2004.

Where does this leave tenants, building owners, buyers and sellers? Tenants will have the upper hand through 2003 and can benefit from signing long-term leases, though many tenants choose shorter terms until the economy looks more stable, by which time the best bargains are history. Owners would benefit from refinancing their debt if they haven’t already, and locking in low fixed rates before the economy and interest rates ramp up.

Companies wanting to buy or build their own facilities should act this year to take advantage of low rates and, in the case of new construction, low costs for land and labor. Companies wanting to sell and lease back their facilities will find a crowd of buyers, with the size of the crowd and the price they’re willing to pay dependent on the credit quality of the tenant. Investor demand remains strong for class A office properties and modern industrial buildings leased to credit tenants with little rollover risk for the next three years.

As the economy improves and interest rates trickle higher, perhaps beginning late this year, real estate will look less attractive to investors than it does today.

Additional company market data can be found here.

Robert Bach is national director of market analysis for Northbrook, IL-based Grubb & Ellis Co. Bach prepares the firm’s national market-trend publications, including Office, Industrial, Retail, Multifamily and Telecom Market Trends, as well as the National Forecast Book. He also oversees the preparation of approximately 75 Metro Trends reports covering quarterly market conditions in metropolitan office and industrial markets.

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