Washington Vies with New York for Highest Office Rents

Continued weakness in the employment sector fueled an ongoing rise in office vacancy rates. Office occupancy fell 15.8 million feet in the fourth quarter, the eighth straight decline, according to real estate analysts at Reis. Reis doesn't expect a turnaround until businesses begin hiring again.New York's vacancy rate rose just 0.1% to 11.5%, but that came at a big cost: Effective office rents fell 5.3% in the fourth quarter and almost 20% year-over-year, the largest fall since Reis began tracking data in 1980. Nationwide, the vacancy rate climbed to 17% from 14.5% a year earlier. Effective rents, the rent paid to landlords after concessions, fell 8.9% to an average of $22.44, another record for largest fall.

Wall Street Down, Government Up

New York's office vacancy rate started to climb dramatically after Lehman Brothers collapsed in September 2008 and has not yet recovered. New York's loss puts Washington, DC, on track to overtake New York as the most expensive place to rent office space in the U.S. That's thanks to the government expansion and the increase in the need for rental space in the nation's capital for firms that do business with government, including lobbyists, corporations and contractors.

New York and Washington have long battled for top spot. The fortunes of New York are dependent on the financial industry, while D.C. obviously is dependent on the size of the government. Since the fall of Lehman Brothers, the average rent in midtown Manhattan fell from $61 per square foot to $44.69 in the fourth quarter of 2009 and Reis expects that to fall to $41.07 by the end of 2009. DC rents are falling, but much more slowly at a rate of 3%. Average rents in DC were $41.77 at the end of the fourth quarter and Reis expects them to fall to $41.27. If Reis's predictions are right then DC will overtake New York as the most expensive city for office space in 2010.

Yet prestigious addresses in New York can't be beat anywhere in the U.S. For example in December Brazil's Banco Itau signed a lease for $130 per square foot for half of the top floor of the General Motors Building on Fifth Avenue with views of Central Park. (Although that may sound high, it's actually down by 50% from what it would have fetched three years ago.)

Fueling Washington's success are new federal government rentals, as well companies and contractors that need close access to the government. In the fourth quarter of 2009 alone the Department of Agriculture leased 330,000 feet in southwest Washington. In total the General Services Administration, which handles leases for government agencies, leased an additional 1.4 million square feet in 2009. The Department of Homeland Security wants an additional 1.1 million square feet and the Department of Veterans Affairs is looking for 300,000 square feet.

Added to the governmental office space needs are the increasing number of corporations moving to the Washington area, such as Northrop Grumman's planned move from Los Angeles to the Washington, DC area, as well as a planned move by Hilton Hotels Corp. to Washington from Beverly Hills. These corporations will likely choose offices in Virginia or Maryland, depending upon the incentives they get.

The one factor that could hurt the DC area in the long term is that there is a lot of new office construction under way, which could eventually knock DC off its perch at the top, as vacancies rise until the new space is absorbed by the marketplace. Long term as the financial markets heal and DC changes political leadership, New York will likely take the top spot back from DC.

Banks Could Suffer

But as these two cities duke it out, the bigger question is what will happen to the regional banks? With office rentals dropping as well as apartment rentals, that means owners of these buildings will be hurting for cash. This will likely result in an increase in defaults of commercial real estate loans, which could be devastating to regional banks.

Banks and investors hold about $3.5 trillion in commercial real estate loans, including malls, office buildings and apartments, based on a June 2009 report from the Fed. About $1.7 trillion of that total is held by banks and thrifts. Regional banks are almost four times more concentrated on property loans than the nation's biggest banks, based on data compiled by Bloomberg. In 2009, 140 banks failed, and as of the latest FDIC quarterly report in November 2009, 552 banks were in trouble. Mortgage and commercial lending problems have fueled most of the bank failures so far.

Unless the economy turns around more quickly than now predicted and jobs rebound, you can expect to see more commercial loan defaults in 2010 and 2011, which likely will mean more bank failures.
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