Back to Business?

Office leasing shows early signs of improvement amid a fragile economic recovery.

Office markets across the country continue to battle the lingering effects of the recession. But many cities are beginning to shed the high vacancies and fat concession packages that have dominated the last few years as expansion activity slowly returns.

A year ago, cost-conscious tenants were fueling the bulk of the leasing activity. Firms moved to take advantage of discounted rents or reduced expenses by downsizing or consolidating office space. Tenants negotiated "blend and extend" deals — rent reductions in exchange for longer lease terms — well in advance of lease expirations. These tactics were common in markets all across the country.

Confidence Returns

Those factors continue to drive transactions, but the notable difference is that corporate confidence appears to be returning. "I am not seeing the same level of uncertainty, downsizing, and emphasis on shorter-term leases that was more prevalent in the market a year ago," says David H. Johnson, CCIM, managing principal at Mohr Partners in Denver. Office tenants are planning for future growth and are more willing to commit to long-term deals. "A lot of companies that were looking last year had leases that were expiring in 18 to 24 months and were looking to capitalize on a very weak market. The deals that I am working on now are real deals with actual lease expirations," Johnson adds.

That being said, expansion activity is not widespread across the board. The rebound varies widely depending on the industry and geographic market. For example, information technology, healthcare, mining, and financial services are a few of the sectors that are growing in Denver, while oil and gas-related companies are leading the demand for space in Houston.

"In Texas, we are beginning to see growth and expansion that is definitelybullish," says Ron Miranda, CCIM, SIOR, a senior vice president at Thompson National Properties in Houston. "The strongest tenants are looking to lock in long-term deals."

Miranda recently completed a $160 million lease for a large law firm whose strategy was just that — secure a long-term lease and get back to business. "There is still some right-sizing as firms try to peg their future lease space requirements, which could mean growth for the future or contraction from underutilized office space," he adds.

After nearly three years of rising vacancies, the national office market turned an important corner in 2011 with improvements in key fundamentals. Positive absorption of more than 9 million square feet during the first half of the year helped to push the national office vacancy rate off its peak level of 17.6 percent, recorded in both the third and fourth quarters of 2010, according to Reis. The vacancy rate improved by 10 basis points to 17.5 percent in 1Q11 and held steady in the second quarter. Reis is predicting that vacancies will fall to 17.1 percent by year-end.

Another encouraging sign is that both asking and effective rental rates also are improving. During the first half of 2011, asking and effective rates logged their second consecutive quarter of rate increases — improving about 0.7 percent or an average of $22.25 for effective rates and $27.72 for asking rents.
"That is a fairly healthy improvement given that this is not the most spectacular economic recovery," says Ryan Severino, a Reis senior economist. Reis is forecasting that asking and effective rates will increase by a total of 1.5 percent and 1.7 percent respectively for the year. "Given how daunting the past recession was, most participants in the market are just happy that we have gotten past a stabilization point and we can actually start to talk about a bit of a recovery in this market," says Severino.

Market Disparity

The caveat to this market recovery is that it varies widely depending on the dynamics of the local economy. "On a metro level basis, it is not as if the tide is lifting all boats just yet," Severino says. "A lot of that has to do with what is happening at the micro level in these local economies, and that is going to be an incredibly varied and mixed bag at this point."

Clearly, many secondary and tertiary markets across the country are still waiting for job growth to return and spark a recovery in the office sector. Atlanta is one market that has seen its office vacancy stall at about 21 percent as it waits for job growth to return. "Right now we are just seeing a real hesitancy and anxiety about committing to growth by hiring," says Andy Sumlin, CCIM, director of project leasing at Barry Real Estate Companies in Atlanta.

Office leasing activity that is occurring in Atlanta is being fueled largely by companies looking to capitalize on favorable rental rates or "right-sizing" real estate. "There is an improvement in activity, but because of the lack of job growth, we are not making any statistical gains," Sumlin says. "We are just seeing a lot more companies across the spectrum in type and size trying to take advantage of the current market the best they can."

Silverdale, Wash., is another community still waiting for its office market recovery to begin. "We have 406 commercial spaces empty — about 300 are office space," says Merv Killoran, CCIM, manager of commercial investment at Reid Real Estate. Those vacancies represent about 20 percent of the overall market. Silverdale has been hard hit by small businesses that closed or consolidated as they struggled in the recession. "The remaining tenants are in such a strong bargaining position that they are pretty much holding their current landlords hostage," Killoran says. "They are threatening to leave unless their lease is renegotiated and rents go down."

The Job Factor

It is no surprise that the office market recovery is all about jobs, jobs, jobs. "Usually, there is about a 12- to 18-month lag between when the labor market turns around and when you start to see office leasing activity pick up again and improvement in fundamentals such as vacancies and absorption," Severino says.

The labor market began to generate consistent job growth in 2010. During the 16-month period between March 2010 and June 2011, the U.S. economy added nearly 1.8 million jobs. However, the monthly job gains varied widely from a loss of 192,000 jobs in June 2010 to a gain of 458,000 jobs in May 2010, according to the Bureau of Labor Statistics.

An improving economy and job growth is the No. 1 factor behind an increase in office leasing activity in Raleigh-Durham. Job growth began returning in 1Q10, particularly in sectors such as healthcare, technology, and financial services. "We also have a pretty good entrepreneurial community these days, and that shows particularly in the downtowns of both Raleigh and Durham," says Gregory T. Payne, CCIM, a broker at Pickett-Sprouse Real Estate in Durham, N.C. The region has seen a proliferation of start-ups, particularly in technology and gaming, moving into older warehouse and loft spaces that have helped to keep vacancies down. Part of that activity is due to a concentrated effort to encourage entrepreneurial growth.

For example, the Durham Chamber of Commerce launched a new program earlier this year aimed specifically at fostering new business growth. The Bull City Start Up Stampede provided two months of free office space with added perks such as furniture, Wi-Fi, and parking to help new businesses "get out of the basement" and get started. "That emphasis on courting entrepreneurs is something that we didn't see in this market 10 years ago," Payne says.

Long-Term Lock-in

Class A properties continue to be a hot bed of activity as tenants upgrade from class B or A- buildings to class A or A+ properties. Although statistics show that both asking and effective rents are improving, rent discounts and concessions are still widely available across many secondary and tertiary markets. The norm in markets such as Denver is one free month for each year of the lease term, while concessions in Atlanta are running as high as 1.75 months of free rent for every year of the lease term.

"That flight to quality governs more transactions than anything else right now, particularly if a tenant is coming out of a lease that they have been in for some time," Sumlin says. Those tenants are paying about the same rate in an existing lease at a class B+ building as they can get in a class A building today. "So they are able to upgrade their product without really impacting their cash flow," he adds.

Concessions are another factor motivating tenants to lock in long–term leases. To secure the best deals, tenants need to commit to long-term deals. Companies also recognize that those deals may soon start to disappear as the economic recovery gains traction. What is more promising is that those long-term commitments show that companies are ready to move forward: Either they are more confident in their business outlook, or they have adapted to the new business climate.

Two years ago, the prevalent strategy among corporate and small–business tenants alike was to adopt "wait and see strategies" and shorter-term leases. Smaller, more entrepreneurial companies are still exhibiting a desire for more flexibility and shorter terms. "Yet there has been a shift where we are now seeing longer-term commitments on the corporate side as they establish the new normal. They can understand their revenue and are willing now to commit to seven and 10-year leases," Sumlin says.

"Some of my clients are definitely expanding, not only in Denver, but nationally," agrees Johnson. For example, Johnson recently represented two financial companies in separate deals — both of which agreed to six- and seven-year leases to secure more favorable rent discounts and higher tenant improvement packages as they moved from class B to class A space.

Johnson interprets these deals as a strong indication that companies are ready to stop second-guessing the economic signals and get back to work. "These companies are making real commitments to new space," he says. "That will give them the ability to retain and recruit employees as they prepare for the next business cycle."

Beth Mattson-Teig is a business writer based in Minneapolis, Minn.

Beth Mattson-Teig

Beth Mattson-Teig is a business writer based in Minneapolis.