At first glance, the national office market today appears to be in the same position as it was 12 months ago. Hope sprang eternal then, as many believed the worst had passed and positive absorption and rent growth were around the corner. Optimists were disappointed, however, as the office sector continued to suffer from anemic job growth and supplementary new supply. Since then, the national vacancy rate has increased from 15.7 percent to nearly 16.7 percent, while effective rents have plummeted an additional 3.2 percent after a 7.9 percent fall in 2002. Yet, after further hemorrhaging, market players are clinging to the hope that the recovery is just around the corner. Today, unlike in 2002, there seems to be more evidence that a turnaround is in the offing.

While the office market remains mired in its 3-year slump, the general economy is already far on the road to recovery. Productivity, GDP [gross domestic product] and employment figures all show positive improvements and are gaining momentum as the economically stimulating holiday season approaches. As of mid-August, the Dow Jones Industrial Average, NASDAQ and S&P were all up more than 20 percent year-to-date and corporate profits also exhibited solid gains. The uncertainty surrounding the war with Iraq paralyzed many decision-makers; this uncertainty has passed, as evidenced by increased mergers and acquisitions in the second half of the year. Even the battered airline industry appears to be rebounding from the effects of September 11, 2001, and SARS, as it registered strong load numbers in July.

Conversely, in spite of all the positive news in the marketplace, office employment lags the overall rebound, as employers continued to reduce payrolls during the first half of 2003. Hiring activity has started to gain minimal traction during the second half of the year, but hiring will be limited until companies are more comfortable with the economic recovery. From a historical perspective, current office employment numbers trail those of the previous two recessions at this point in the cycle. Twenty-seven months after the 1981 recession, office employment was 6 percent ahead of where it was at the start of the recession, while at the same interval after the 1990 recession, office employment was only 1.4 percent below the pre-recession figure. August marked 27 months since the beginning of the recent recession and office employment remained 3.4 percent below where it was at the beginning of the recession. Therefore, it is logical to project that even as the economy has registered several quarters of positive growth, employers will be cautious before dramatically increasing the size of their payrolls.

Consequently, the limited office employment growth at the end of 2003 will have no positive material effect on the vacancy rate, as new supply will still outnumber the minimal increase in demand. Current projections by Economy.com put office employment job growth at approximately 3 percent for 2004, which would translate into substantial demand for space, leading to positive absorption. While the projections favor the latter half of the year, office employment growth during the first half of 2004 should be enough to drive positive absorption and a slight reduction in the vacancy rate.

The increase in demand through 2004 will produce a reduction in the vacancy rate due to a dwindling pipeline of new construction. While this scenario will play out in the vast majority of markets across the country, there are exceptions where office construction remains robust.

During the boom years of 1997 to 2001, suburban areas delivered more new office space as a percentage of existing space than the nation’s downtown markets. Subsequent to these record years, suburban pipelines diminished rapidly and in many markets have dried up completely. With little construction anticipated over the next 12 to 24 months, the suburbs, which currently support a higher vacancy rate, will see a quicker increase in occupancy during the rebound. Meanwhile, many downtown areas will witness additional deliveries over next 12 to 24 months, which will hamper their ability to reduce vacancies as quickly as the suburban markets.

Taking the above information into account, the office market should have the necessary footing to begin a sustainable recovery in 2004. On the supply side, new deliveries over the next 12 months will be a miniscule fraction compared to the boom years. As office job growth returns to the market in early 2004, demand for office space will begin to steadily increase. Combined with limited new supply, absorption will turn positive and help reduce the national vacancy rate by 30 to 60 basis points by the end of 2004. Rent growth will probably lag the increase in occupancy as there is still a good deal of available space in the market. At a vacancy rate of more than 16 percent, competition for tenants will remain very heated, which will provide a negotiation advantage for tenants. Substantial rent growth should begin to emerge at the end of 2004 and into 2005.

Atlanta

After a sizeable decline in office investment sales activity in 2002, the Atlanta office market has rebounded in 2003 and is poised to exhibit a substantial increase in transaction velocity by year-end. Sales activity in 2002 was hampered by the stiff increase in vacancy that occurred in the fourth quarter of 2001 and into the first half of 2002. The vacancy rate climbed 580 basis points or nearly 48 percent, from 12.2 to 18 percent. This steep increase alarmed investors and pushed many potential buyers to the sidelines. At the same time, owners were grappling with significant new vacancies and decreasing rents and could not meet their pricing objectives. Activity began to increase during the second half of the year, but transaction velocity concluded the year down more than 11 percent. However, even with a negligible increase in dollar volume, the median price per square foot increased by 3 percent. Due to the lower activity levels, quality assets were achieving higher prices, while lower interest rates allowed buyers to pay more for properties and still maintain their return requirements.

Although the leasing market has continued its downward trend in 2003, albeit at a much reduced pace, investors have shrugged off the effects of the initial shock and are actively pursuing properties in the market. As of the end of June, nearly 58 transactions had closed; dollar volume has dipped, though, as investors pursue smaller properties that have witnessed less adverse effects from the office market slump. As a result of this pursuit of smaller, better leased properties, sellers have gained an advantage in the market that has median prices up by an additional 16 percent in 2003. Active buyers in 2003 include Windrose Medical Properties and Wells Real Estate Investment Trust, while sellers include Prentiss Properties and CMD Realty. Medical office properties are drawing extremely strong interest as investors desire the quality and stability of these properties. Although they have only purchased a scant number of deals this year, German investors continue to scour the Atlanta market for investment opportunities. Due to their low yield requirements, German investors tend to pay higher prices, helping push cap rates down for the entire market. Several German-funded advisors are located in Atlanta, including Jamestown and TMW, now a division of Prudential Real Estate Investors. These funds not only bring their own investment dollars to Atlanta, but focus other German-oriented funds on the market.

Atlanta has proven that it can quickly expand its economy, and its performance in the current rebound cycle should be nothing short of robust. This reputation will enhance investors’ appetite for properties, granting sellers a captive and well-paying audience.

Miami

After a horrific beginning to the investment year, the Miami office market has accelerated over the last 4 months and is now on pace to witness a substantial increase in transaction velocity. Through June, more than 40 transactions had closed, nearly half of the total velocity in 2002. However, the composition of transactions has altered greatly from last year when numerous trophy properties changed hands. The typical transaction in 2003 has been a multi-tenant, low-rise building priced between $3 million and $5 million. While German investors were very active in this market last year, up to this point they have only been active on the sell side in 2003. The typical buyer profile has been a local private corporation or individual, including a handful of 1031 exchange buyers looking to garner a higher return than in other product types. Median prices on a per-square-foot basis have increased 1 percent year-to-date, after a steep 16 percent increase in 2002.

The robust performance of the Miami office investment market over the last several years is a product of many characteristics. First, Miami is almost entirely built-out with the Everglades and the Atlantic Ocean boxing in the area on two sides. New construction is very limited and new space is usually a product of redevelopment of an existing property, thus limiting the new supply in the market at any given time. Second, although known as a tourist haven, Miami’s economy is quite diverse and added more than 83,000 jobs or 8.7 percent of the total employment between 1998 and 2001. The results of the recession also have been limited due to the economy’s strength, as the market has lost less than two-tenths of a percent, or 2,000 jobs, since the beginning of 2002. Third, Miami’s development as the chief trade hub between the United States and Latin America has fostered growth in many trade companies and their ancillary industries, which, although not immune from recession, carry a greater isolation from short-term market downturns.

In a period where uncertainty reigns, the aforementioned characteristics give comfort to Miami investors, whose confidence in a near-term rebound in the local economy is strong. Regional, national and international investors have taken a more cautious approach, accounting for the steep drop in trophy property sales during the first half of the year. Enticing foreign and institutional buyers back to the market will necessitate growth in jobs and a tangible indication that the local economy is rebounding. Local private entities should continue to form the crux of the investor pool in the near-term, which may lower transaction size, but will also increase transaction velocity.

Only transactions of $500,000 and greater were sourced for this report.

Sources: REIS, PPR-Research, CoStar, Bureau of Labor Statistics, Merrill Lynch, Marcus & Millichap Research.

Alan Pontius is a senior vice president at Marcus & Millichap and serves as national director of the firm’s National Office and Industrial Properties Group. Yitzie Sommer, operations manager of the National Office and Industrial Properties Group, also contributed to this article.

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