Economist's Commentary: October 1, 2008

Office Market Trends

By George Ratiu, Research Economist

The financial crisis on Wall Street is exacerbating the effects of a slow economy. Job growth, particularly in office-using industries, has been declining. With the demise of Bear Stearns, Countrywide, and IndyMac in the second quarter of this year, followed by Merrill Lynch, Lehman Brothers, Wachovia and Washington Mutual in September, job growth and, implicitly, demand for office space have been negatively impacted.

The current economic conditions, especially in light of the financial industry collapse, are causing many companies to curtail expansion plans. And while new development construction has clearly slowed due to higher construction costs and tighter financing, the concern is that there is already oversupply in the market. For the first half of 2008, there were 33.6 million square feet of completed office space, compared with 28.5 million square feet during the same period last year. Completions are expected to slow to 7.5 million square feet for the third quarter.

The combination of decreased demand and new construction is causing steep declines in absorption. For the first half of 2008, net absorption is down by 21.6 million square feet, compared with the first half of 2007. Based on the current situation, absorption will likely continue to drop for the remainder of the year.

Meanwhile, the vacancy rate is projected to edge up slightly, from 13.2 percent in the second quarter of 2008 to 13.3 percent in the third quarter. Office markets with stable employment conditions have been benefiting from increased office space absorption and low vacancy rates. Five metro markets have posted single digit vacancy rates. New York still tops the list of markets with the lowest office vacancy rates, with a vacancy rate of 6.2 percent for the third quarter of 2008. However, given the number of Wall Street firms exiting the market, it remains to be seen how the remainder of the year plays out.

In addition to New York, the list of markets posting single-digit vacancy rates is similar with last quarter's-Honolulu, HI (9.2%); Long Island, NY (9.7%); San Francisco, CA (9.8%). There is an exception-Seattle, WA moved up from ninth place to third, with a 9.5 percent vacancy rate.

Office markets in the Midwest and Southwest have been hurt the most from weakening demand. The Detroit, MI office vacancy is 21.4 percent, followed closely by Dallas, TX, with a 20.7 percent vacancy rate. The other markets with high vacancy rates are both in Arizona-Tucson (19.1%) and Phoenix (18.8%). Office vacancy is also on the upswing in some Florida markets. West Palm Beach vacancy has risen to 18.4 percent, while Jacksonville is up to 18.1 percent.

In step with rising vacancies, rent growth for office space is registering marked declines. Look for rents to increase 3.2 percent in 2008, compared with 9.5 percent last year.

Office fundamentals are clearly impacted by the current turmoil in the financial markets. The events of this quarter are likely to be the bellwether for the overall economy, and provide an indication of the office market's direction in the following months.

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