Grubb & Ellis's Bach Says Office Market is in 'Orderly Retreat'--Not a Rout

U.S. Office Market First Look: 2008-Q4

SANTA ANA, CA--Bob Bach, senior vice president and chief economist, Grubb & Ellis Co., reports:

· With the office market in the path of a deepening recession, market fundamentals are softening, but at a measured pace. The rate of deterioration is more like an orderly retreat than a rout, at least so far.

· The vacancy rate ended the year at 14.8 percent, an increase of 50 basis points in the fourth quarter and 180 basis points for the year. Vacancy rose by 50 basis points in the first, second and fourth quarters of 2008 and by 30 basis points in the third quarter.

(Colby Abbot Building, Milwaukee, WI, top left photo)

During 2001, when the economy was last in recession (from March to November of that year), the vacancy rate increased by an average of 141 basis points per quarter – hence the observation that the deterioration in the current cycle has been less severe despite the greater intensity of the current recession.

· Only three major markets posted sub-10 percent vacancy rates at year-end 2008: New York City, Long Island and the New York Outer Boroughs – a twist of irony considering the woes on Wall Street.

This is proof positive that vacancy rates do not tell the whole story because different markets have different equilibrium vacancy rates.

Seven markets posted vacancy rates above 20 percent with Phoenix dethroning Detroit for the dubious honor of the softest major office market in the U.S.

· During 2008, vacancy increased by eight percentage points or more in California’s Inland Empire, Austin and Phoenix. Vacancy fell – but only modestly – in an eclectic mix of eight markets led by Greenville, S.C., Wichita, Kan. and Pittsburgh.

· Net absorption stayed negative for a third consecutive quarter, totaling -2.2 million square feet in the fourth quarter and -3.4 million square feet for the year. During the opening four quarters of the prior softening cycle, by comparison, tenants gave back 77 million square feet of office space, another sign that the current cycle has been moderate thus far.

· Three markets ended the year with positive absorption in the range of 2 to 3 million square feet: Boston, Washington, D.C. and Dallas-Fort Worth. More surprising were the fourth and fifth place markets – perennially slow-growth Pittsburgh and Baltimore – which beat out energy powerhouse Houston in sixth place.

At the other end of the continuum, New York City, Los Angeles and Orange County all recorded annual negative absorption in the range of -2 to -4 million square feet.

· Space under construction dipped convincingly by 14 million square feet to end the year at 79 million square feet as construction projects were completed and new starts were rare. Metro Washington, D.C. continued to lead all markets with just over 10 million square feet in the pipeline.

(Bank of America Tower, Austin, TX, middle right photo)

· Sublease space broke through the 100 million-square-foot ceiling for the first time since the fourth quarter of 2004. New York City led all markets with 11.8 million square feet of sublease space on the market, up from 6.3 million square feet at the beginning of the year as contracting financial services companies sought to monetize newly emptied space.

· The weighted average asking rental rate for Class A and B space ended the year, respectively, at $35.80 and $26.78 per square foot per year gross. During 2008, asking rates dropped 1.6 percent for Class A space and 1.5 percent for Class B space.

Effective rates were off more sharply as landlords traded rent, in the form of generous free rent periods and tenant improvement allowances, for occupancy.

In some markets, landlords reduced their asking rates, while in other markets they kept asking rates intact while relying on lower “whisper rates” to attract reluctant tenants.

(One Liberty Place, Philadelphia, bottom left photo)

For the most part, tenants were having none of it, opting for short-term extensions when their leases expired so as to keep their long-term options open.

For tenants with leases expiring in a year or two, “blend and extend” offered a win/win strategy. Tenants benefited from immediate rent reductions for the remaining term of their leases, while landlords benefited by signing tenants to new long-term leases.

Forecast

The most plausible explanation for the “orderly retreat” of the office market in the face of a punishing recession is that tenants haven’t had enough time to react.

The labor market fell off a cliff in September 2008 with payroll job losses totaling 1.9 million in the last four months of the year, substantially more than the 1.5 million lost during and after the entire 2001 recession.

The office market lags the economy by six months as a rule of thumb, meaning that the vacancy rate could ascend more rapidly in 2009.

The surprisingly shallow decline in occupied space (negative net absorption) recorded in 2008 raises hopes that tenants won’t give back as much space as in the prior recession, although this could be unrealistic given the massive job losses late last year and the prospects for millions more layoffs this year.

(Los Angeles office buildings skyline, bottom right photo)

Expect the vacancy rate to end 2009 in the range of 16.5 to 17 percent, below the prior peak of 17.9 percent recorded in the first quarter of 2004, although vacancy could surpass that peak early in 2010.

Negative absorption likely will total 40 to 50 million square feet by year-end 2009, with asking rental rates off by 4 to 5 percent and effective rates off by 5 to 10 percent with sharper declines possible in specific markets.

CONTACT: Janice McDill, Vice President, Public & Investor Relations, Grubb & Ellis Company, 500 W. Monroe St., Suite 2800Chicago, Ill., 60661, PH 312.698.6707