Office Vacancies Still Rising, Should Peak in 2011

National office vacancy rates will probably top 18% in 2010, reaching their highest levels ever and forcing landlords to negotiate more concessions with tenants than in the past. Robert Bach, chief economist of commercial real estate firm Grubb & Ellis, says high unemployment and employers' reluctance to hire workers will keep leasing markets deteriorating before they start a slow, multi-year recovery in 2011.

Bach estimates that in 2009, office leasing rates were between 10% and 15% lower than 2008 levels, and he expects rates to continue to decline moderately until sometime next year. Once markets begin to recover in 2011, he believes it will take two to three years for stronger markets like New York, San Francisco and Washington, D.C., to fully recover and four to five years for weaker markets to bounce back. Bach said to look for markets with a lot of completed construction in the pipeline, such as Washington, D.C., to rebound more quickly. Areas like San Francisco, where smaller startup companies tend to spring up, will also recover ahead of the pack. Growing cities like Denver, Austin and San Antonio should also do well whenever the recovery starts in earnest.

Real estate research firm Reis Inc. reported that the national office vacancy rate hit 17% in the fourth quarter of 2009, a 15-year high. According to Grubb & Ellis, the national office vacancy rate at the end of last year was 17.4%. The company predicts vacancy rates of 18.5% to 19% by the end of 2010, which would be the highest rates recorded since Grubb & Ellis began tracking them in 1986.

With such a high percentage of office space vacant as a result of unemployment last year, landlords came under pressure to drop rents as a means of enticing their tenants to renew long-term leases. Bach said many tenants took the drop in rental rates for one year as they tried to figure out how to ride out the bad economy. This year, many tenants may see the deteriorating office market as an opportunity to upgrade their space or cut their overhead costs as demand for office space wanes and incentives such as free months of rent and remodeling of office space are offered as concessions.

"Last year we saw a lot of one-year lease extensions because as leases were expiring, tenants didn't want to sign a new five-year lease because they were so nervous about the economy and their own outlook," Bach said. "This year, I think we will have more tenants decide that now is a good time to sign a longer-term lease because the deals landlords are offering are so good."

Recent events such as the U.S. unemployment rate stabilizing, the European Union's positive response to the debt crisis in Greece and the continuing rally in stocks have created an economic atmosphere that indicates a recovery is underway. Bach believes that since it is a bit clearer what the financial markets and the economy are going to do, that will significantly increase the number of lease deals this year as tenants begin to position themselves for the slow recovery ahead.

"There is confidence that the credit markets are not going to fall off a cliff," Bach said.

Unfortunately, the confidence in the credit markets and economy will not help cash-strapped landlords when it comes to collecting rents. What will help? Striking leasing deals with tenants who can pay.
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