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Has the Office Vacancy Rate Become Irrelevant?

Latest CoStar State of the Market/Industry Outlook Finds Disconnect Between Job Loss Totals and Absorption in the Office Market

By Mark Heschmeyer

April 15, 2009

The U.S. office vacancy rate has not broken through the 13% barrier for 14 years since the end of the great oversupply build-up of the late 1980s and early 1990s. Even now, 15 months into the most severe recession since the 1930s, the U.S. office vacancy rate still hovers below a relatively modest 12.5%.

In its First Quarter 2009 Office Review delivered this week, CoStar Group asked the question: "What's wrong with this picture?"

"Never has a vacancy rate chart been more useless in commercial real estate than right now," Andrew Florance, President and CEO of CoStar Group, told an online audience of more than 800 CoStar clients who viewed the presentation this week. "When the market is moving this rapidly you have to switch gears and look at it from a different angle."

"When you consider the most recent job loss totals and then look for the implied negative absorption in the office market, it's completely missing right now," Florance added. "We've had massive job losses but so far only 20 million square feet of negative absorption."

"Based upon the job losses we've seen to date, we should be seeing something on the order of 450 million square feet of negative absorption compared to the negative 20 [million] we've actually experienced," Florance said. "So there's a complete disconnect right now between job losses and absorption."

Total Available Nearly Double Total Vacant

However, Florance noted that not every job lost will necessarily translate into negative net absorption, nor did he advocate forever writing off the value of the vacancy stat. He did, however, clearly pointed out its inefficiency in analyzing current commercial real estate markets when conditions are undergoing rapid changes and the usually narrow gap between the amount of space listed as vacant and the amount being marketed as available widens considerably.

Delving deep into an analysis of CoStar Group data and supplementing widely used current economic indicators, CoStar Group forecasted that the U.S. office vacancy could shoot up to 18.2% in 2010.

That number is a 300 basis point increase from CoStar Group's forecast issued at the end of 2008 just three months ago. Florance said the predicted increase correlates directly with the worsening labor situation and the predicted increases in the number of jobs that will be lost in the next two years.

Unlike in the mini-recession following the dot.com bust in 2001, negative net absorption now is not immediately detectable, Florance explained.

When the Internet bubble burst in 2001, the impact was immediate. Start-up companies with no operating history that had leased hundreds of thousands of square feet in anticipation of rapid growth went belly up immediately. The space was never occupied and went back on the market immediately, Florance said.

Job losses today are coming from long-established, Fortune 1000 companies. These types of companies, Florance said, are reluctant to give back the space or put it on the market. Hence, there is an abundantly large but hidden supply of available space.

At no other time in the past 25 years has there been so much unlisted, and therefore undetected, space available for lease. There are several reasons for this, Florance said.

  • Tenants have been unwilling to take the hit on their balance sheet from accelerated depreciation and rent loss differential on their leased space.
  • The established tenants are still hopeful about being able to rehire laid off staff.
  • Major tenants such as those in the financial services industry are fighting bigger fires involving billions of dollars and not currently focusing on a few million dollars in underutilized space.
  • Smaller and mid-sized tenants are worried that putting their unused space up for sublease could send an impression that they are not financially stable.
  • Building owners are not recognizing failed tenants so as to avoid any negative impact on their balance sheet.
  • Landlords are having trouble forcing out insolvent tenants. And
  • Lenders are not forcing the issue of recognizing unoccupied space as long as owners are still collecting rents and making loan payments. That way they don't have to write down the value of their loan asset.

CoStar Group tracks both available and vacant space and the discrepancy between the two have been growing increasingly wider since 2006.

At the start of 2006, there was an approximately 300 basis point spread between the then vacancy rate of about 11.25% and the then availability rate of about 14.25%.

Today, that spread is about 1,100 basis points with the total availability of office space now approaching one-fourth of total supply.

Leasing Activity Plummets

Another factor is also working to depress the national office market. The office leasing market experienced a huge drop off in activity this past quarter.

Looking at the 15 largest office markets in the country, total leasing activity is off 46% from what it was in the same period last year. In the first quarter of last year, nearly 71.7 million square feet of deals were completed; that number dropped to 38.8 million in the first quarter of this year.

Only in the Atlanta metro area has leasing activity held up.

Total Leasing Activity

By Market 1Q 2008 1Q 2009 % Decline
New York City 11,341,653 4,913,275 57%
Washington, DC 7,978,117 4,897,472 39%
Chicago 6,291,007 3,047,459 52%
Los Angeles 5,460,099 3,316,846 39%
Boston 5,102,162 2,452,647 52%
Philadelphia 3,457,500 1,602,625 54%
Northern New Jersey 3,368,045 2,305,122 32%
Dallas/Fort Worth 6,511,908 2,575,046 60%
Atlanta 3,975,517 3,972,812 0%
Houston 5,021,679 3,431,621 32%
Westchester/So. CT/Long Island 3,504,940 1,882,646 46%
Detroit 2,145,274 1,055,041 51%
Denver 3,491,316 1,781,824 49%
Seattle/Puget Sound 1,918,413 1,199,681 37%
Minneapolis/St. Paul 2,086,912 391,226 81%
Total 71,654,542 38,825,343 46%

As fewer deals are getting done, available space is staying on the market longer and longer. According to CoStar Group numbers, the average number of days from when a space goes on the market to when a lease is signed has increased from about 270 days at the start of 2006 to 415 days last quarter.

Office Sales Prices Collapse

The last item of really bad news coming out of the CoStar First Quarter 2009 Office Review was that the price of office buildings sold in the first quarter plummeted dramatically.

Class A office prices dropped 21% in the first quarter compared to prices recorded in the previous quarter. Prices peaked in the first quarter of 2008 and are down 51% since then to less than $200/square foot.

Class B office prices dropped 40% in the first quarter compared to prices recorded in the previous quarter. Prices peaked in the third quarter of 2008 and are down 55% since then to about $130/square foot.

Class C office prices dropped 24% in the first quarter compared to prices recorded in the previous quarter. Prices peaked in the third quarter of 2008 and are approaching $116/square foot.

Sales volume is also way down from their unsustainable peak of nearly $18 billion per quarter in early 2007 to a little less than their 30-year historical average of around $2 billion in deals per quarter this past quarter.

Jonathan A. Sarnat
Empire South Commercial Real Estate, LLC