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Barbara Nelson is editor of Real Estate New York.

NEW YORK CITY-The balance between supply and demand in the office market in Manhattan is reaching critical mass, with repercussions being felt throughout the market by the end of 2007, says David Arena, president of Grubb & Ellis New York, at a forecast breakfast Wednesday.

In the last two decades, development of speculative office space, due to high construction costs and lack of developable space in Manhattan, has been slow. “We are critically undersupplied,” Arena says. “There’s just 25 million sf available amongst the 360 million sf of office space in New York City.”

Four large financial services firm in Midtown are now looking to expand with no real options to do so. “They need space for their traders. One firm has closed off a stairwell between trading floors to expand,” Arena says.

Grubb & Ellis predicts rents will continue to rise in Midtown as well as Downtown. Manhattan’s direct average asking rents climbed to $65.80 in the Q3, surpassing the historical peak of $64.15 in 2000. Midtown asking rents are expected to reach $75 per sf and Downtown asking rents will rise to $55 by 2007/2008. “Historically there has been a spread of $20 per sf between Downtown and Midtown,” he says. “That historic average will be true again. This is going to happen. It has happened twice in my career.”

Companies will also seriously consider alternative locales for back office workers such as Jersey City; Stamford, CT; Brooklyn and Westchester, NY. in reaction to demand that is predicted to grow by 4% per year; requiring 3.2 million new office space per year. Speculative office development is expected to accelerate to meet that demand.

That growth is likely to occur in Midtown, west of Seventh Avenue along the 42 Street and 34 Street axis. “We expect tenants will pay a premium for high quality assets with better security, close proximity to transportation hubs, large efficient floor plates and green or sustainable characteristics.”

Elsewhere in the country, the real estate market is not as tight. In fact, the rest of the country is still in recovery mode after 9/11, according to Robert Bach, senior vice president of research & client services for Grubb & Ellis. “We are bullish about the office market,” Bach says. “The economy is cooling off, because it is finally reacting to the Fed’s 17 interest rate hikes. It has not yet reached bottom. Short-term rates have leveled off, while long-term rates have actually gone down. It seems to be in the middle of a soft landing.”

Vacancy rates nationwide, although not as low as New York City’s 7.3%, will continue to decline. “We see US office vacancy rates declining to 13.2% in 2007, compared to a year end of 13.6% in 2006,” Bach says.

Demand for industrial space also remains high, especially around ports in Northern New Jersey, Pennsylvania and Southern California. “Industrial is further along in the recovery than office,” he says.

The question remains: “Is real estate over priced as an asset class or was it under priced during the 1990s? That’s a question that will play out for the rest of next year, with demand remaining strong,” Bach says.

Internationally, Steven Mallen, senior managing director and global client services consultant with Grubb & Ellis, says “real estate worldwide is undergoing a revolution. Supply is tracking demand better than it ever has before. Real estate has matured as an asset class in first decade of this century.”

With better lending practices and improved ways to access risk, investments worldwide will reach $600 billion by the end of 2006, with that rising to $700 billion by the end of 2007, a marked increase from 2005′s $450 billion and 2004′s $300 billion, Mallen notes.

With real estate investment opportunities dwindling here, US investors mostly originating in New York, have looked oversees. The hottest countries in the emerging markets are Korea, India and China. The next hot spots, Mallen predicts, will be Thailand, Malaysia, the Philippines and Taiwan.

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