At first glance the office market today appears to be in the same position as it was 12 months ago. Hope sprung 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 and employment figures are all showing positive improvements and are gaining momentum as the economically stimulating holiday season approaches. As of mid-August, the Dow Jones Industrial Average, NASDAQ and the S&P were all up more than 20 percent year-to-date and corporate profits were also exhibiting solid gains. The uncertainty that surrounded the war in Iraq and paralyzed many decision-makers also has passed, 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 Sept. 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 most 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. For example, nearly 4 million square feet of new Class A office space will be delivered in downtown Chicago over the next 2 years. Although nearly 63 percent of this space is pre-leased, it is mostly the result of shifts in space and not the absorption of new space. Chicago also highlights an important trend developing within the downtown and suburban office markets. During the boom years of 1997-2001, 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 such as Chicago will witness additional deliveries over the next 12 to 24 months, which will hamper their ability to reduce vacancies as quickly as the suburban markets.

Taking all 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.

Orange County

Signs of a recovery in the Orange County submarket have been evident over the last 9 months and investors have taken notice. After a record breaking year for transaction velocity in 2002, Orange County is on pace to shatter that record in 2003. Through June, more than 70 office transactions had closed, putting the market on pace for over 150 transactions, an increase of 25 percent. Dollar volume has also exhibited strong increases as strongly capitalized investors such as institutions, REITs and pension fund advisors have purchased Class A and trophy properties in Orange County. Some of this year’s sellers have included DRA Advisors, Great Point Investors, CT Realty and Equity Office Properties. Buyers have included Triple Net Properties, Principal Life Insurance Group, PS Business Parks and Adler Realty Investments, while many other prominent national participants have been outbid by a host of local private entities. All the buyer activity in the market has yielded a further increase in the median price per square foot of approximately 5 percent. The greatest impetus for the price increase has clearly been the historically low interest rates at the beginning of the year. However, even as interest rates spiked in late July and early August, prices were able to maintain positive momentum due to the continued high buyer demand. Larger properties have posted the greatest price increase because the buyer pool is well-stocked and highly competitive. However, investors also see strong opportunity in medium and smaller properties and thus are willing to pay a premium.

Building operations continue to have only a minimal impact on investment sales, as investors are focusing more on the long-term and fundamental strength of the market as opposed to any short-term hitches. One recent adjustment within the operational business will have a huge impact on the investment sales market moving forward. On August 1, Edison Electric instituted a 13 to 19 percent reduction in electrical prices for properties in its coverage area. This includes nearly 80 percent of the Orange County market, only excluding a few small communities in the far south end of the county that are covered by San Diego Gas & Electric. This reduction in rates will have a direct impact on buildings’ net operating income of anywhere from a few thousand dollars to well over $100,000. The effect of this increase to the NOI should commence over the next 6 to 12 months, which will give sellers a greater advantage in the market.

The strong investment market has been slightly tempered by increased lender scrutiny, due to the anemic national economy and the slow rebound in office employment. However, the unquestionable long-term strength of the market will continue to attract capital from across the region and allow investment activity to maintain its strong pace. Owners will see further growth in prices through the end of the year, placing them in excellent position as the local office market grows stronger in 2004.

San Diego

Similar to the bizarre weather that has inhabited San Diego this summer, the local office investment market has also deviated from normal convention. First, from an operations standpoint, San Diego has maintained a relatively low vacancy rate of 12.9 percent, nearly 400 basis points below the national average. Effective rents are only 5 percent off their highs and have already started to creep back up to pre-recession levels. Certain submarkets, however, have been harder hit, such as Del Mar Heights and Sorrento Mesa, where vacancies are well over 20 percent and effective rents have dropped substantially since their recent highs. Absorption was slightly positive in the first half of the year and subsequent leasing activity suggests that positive absorption will continue to grow through the remainder of the year. San Diego continues to benefit from a diverse economy that has fostered a strong contingent of bio-tech companies to complement its defense, tourism, telecommunications and high-tech industries. Between 1998 and 2002, San Diego added more than 165,000 jobs, an increase of 13.3 percent in total employment. As of June, the unemployment rate stood at 4.5 percent, significantly below the state and national rates.

This contrary behavior has resulted in one of the strongest investment sales markets in the country. In 2002, office transactions were up a robust 19 percent, while dollar volume increased an astounding 35 percent and median prices rose 14 percent. The momentum has slowed in 2003, but mid-year statistics suggest another strong year for investment sales. At mid-year, transaction velocity was projected to decrease a minimal 3 percent, but dollar volume was on pace for a record $1.3 billion, a 10 percent increase from 2002. Prices showed no signs of retreating, rising to a median price of $150 per square foot, an 8 percent increase since last year.

The strong fundamentals in the market have fueled an already hungry investor pool that has not hesitated to pay a premium for local properties. On larger deals, national investors consisting of REITs, pension fund advisors and insurance companies have eagerly sought well-leased properties at cap rates dipping below 8 percent. The competition between these groups has fostered a seller’s environment that has produced a surge in trophy property activity. The activity level on smaller sized transactions has been just as strong as new investors have flowed into the market over the last 24 months. New investors have been segmented into two separate categories, those trading out of other property types into office and those investors completely new to the market. However, both groups are arriving at office investment for identical reasons: Cap rates on multifamily properties have in many cases dipped below 6 percent, while retail and industrial cap rates are only slightly higher. Therefore, investors selling multifamily or other products are reluctant to re-invest in these markets, when the office market — even with its recent surge in prices — offers a higher return. Investors new to San Diego are witnessing the same phenomenon and therefore investing their money in office properties where they can achieve a strong return and still feel comfortable with the level of risk.

The already evident and tangible rebound of the leasing market and the strength of the return in the office market in contrast to other property types, provide ample evidence that the market should continue to see growth in its investment market. Transaction velocity may slow, simply due to the high velocity over the last 3 years, but such an event would only encourage further price growth as the same investors compete for a smaller quantity of available property.

**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 L. 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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