Office Market Rolling Over - Why It Matters

If you are considering investing in Manhattan residential real estate, the state of the Manhattan office market matters to you. "Of course" you reply, "the city's economy and economic outlook are a factor that I consider relevant to my decision, but, hey, the state of the office market in Manhattan could be impacted by so many things, why would this one metric be of interest to me?"

I'll argue here that the Manhattan office market is and has been for several years, purely a demand-driven market, supply just isn't a big factor. Further, I will aver that as a result of the tight supply situation, which, under normal circumstances looked likely to persist for at least a couple more years, few employers in New York want to risk running out of space and/or having to find new space at substantially higher rents. For these reasons it is particularly notable that the commercial market in New York is softening fast. It argues that space reductions are being made despite the fact that space might be quite tight in the next upturn, indicating that those cutting back expect their employment levels in Manhattan to remain lower for several years to come. Of course they could be wrong, as they have been in several other downturns, but this time, as Noah has predicted here previously, the whole model for banks and investment banks looks to be changing to one that will limit the size of these institutions for a long time to come, and they constitute a very large percentage of both the office market and employment in the city.

So let's take a look at the numbahs. According to Scott Latham, Executive Vice President of Cushman & Wakefield, as quoted earlier this year on The Stoler Report, during the 1960s, 1970s and 1980s builders delivered an average of 56.5 million square feet of new commercial office space per decade, plus or minus. In the 1990s and 2000s 15.5 million feet of new space was delivered while 25 million feet of commercial space was converted to other uses. The city has been experiencing demand growth of about 3.5 million square feet per year typically.

The Manhattan office market constitutes an estimated 350 million square feet of space. So the typical annual addition of space recently has been 1% of the total. As you can tell, it would take several years of space additions with no increase in demand to cause vacancy rates to move up 3 percentage points. Another way to look at it is that as the economy recovered from 9/11, between 2004 to 2006 vacancy rates fell from 10.9% to 5% and 30 million square feet of space was absorbed. Voila! demand-driven market. (Although 14.5MM square feet came out of the market as a result of the World Trade Center attack, the market demanded another 16.5 million feet of space, or another 4.7 year's worth of typical supply growth.)

Regarding the current market fundamentals, office leasing fell 9.3% year to year in square feet terms in H2 2007. By May of this year, the Manhattan Class A Office vacancy rate was 6.9%, according to Colliers ABR information reported in The Real Deal, up from 6.4% in April, 5.3% in January and less than 5% in 2007. The last two quarters (Q407 and Q108) reportedly saw negative absorption of 2 million square feet after several years of net absorption. In the last two years rent growth was 20% per year, although this slowed significantly in the second half of 2007. During the first half of 2008 rents have reportedly continued to rise by 1 – 1.5% per month.

While on the surface the numbers appear to only suggest a deceleration, according to a recent Crain's Article ,"Manhattan's once red-hot commercial real estate market is developing a chill. Vacancy rates are edging higher. The pace of new lease signings is flagging, and the volume of sublease space hitting the market is soaring. More important, for the first time in six years, effective rents have begun to fall."

The key word here is effective rents. Effective rents factor in the tenant improvement funds and other concessions and giveaways that landlords throw in to get tenants to sign new leases. Effective rent declines are usually a leading indicator of actual rent declines.

Another factor that portends outright rent declines is sub-lease space available. Sub-lease space represents a liability that a tenant is carrying for space they can no longer fill. Such tenants are usually more concerned with getting the liability off their books....getting the space filled with bodies, than maximizing the rent they receive. The availability of cheap sub-lease space puts significant pressure on prices generally. According to the Crain's article, "In the last five months, 5.3 million square feet of sublease space has landed on the market, a jump of 51%. That space now accounts for 19% of the 27.5 million square feet available for rent. Experts say that when sublease space reaches 35% to 40% of the total, it begins to pull all prices down." It is natural to think that with Wall Street layoffs continuing to mount, this activity is bound to increase significantly in the near term and get into the danger zone.

According to a recent Reuters article, Marc Holliday, CEO of Manhattan office-focused REIT SL Green, said that "he expects effective rents -- rents paid after factoring in free months of rent and other incentives -- to fall between 10 and 15% from their highs reached last year, as sublease space from financial firms hits the market. But the sublease space and the lower rents probably won't appear for another 12 to 18 months as financial firms figure out what they want to do and put plans in place to do it." My guess is that things unfold a little faster than that.

When looking at how layoffs could impact vacancies, the number people usually throw around is 250 square feet per person. If an additional 40,000 layoffs are in the cards over the next year (less than half of what the NY City Comptroller estimates as many job losses may not be office jobs), this would equate to 7.5 million square feet of office space to come on the market, or about 3.5 percentage points of vacancy. Since about 33% of the city's office space is leased by financial firms, it could be fairly easy for empty space to pile up, even without the contribution of many more layoffs by the very biggest firms.

From the Blogosphere

Sources: Job Loss Not a Harbinger of Vacancy

Firms Shed Space, Vacancies Jump

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