More Short-term Pain for the Office Market but Signs of Recovery by Year-end

With the onslaught of negative news concerning the economy, many are tempted to think the recession will never end. This is of course not the case as this recession will indeed end, and almost certainly by year-end. While the recovery will be slow and uneven, the economy will begin to expand once again after one of the most severe downturns since the Great Depression. The intent of this “Analysis” is to provide readers with two likely scenarios for the US office leasing market for the balance of 2009 and into 2010, both of which show considerable challenges but also the seeds of recovery.

Economic Assumptions
While the recently announced stimulus package will make a difference at the margin, the economy will shrink in both the first and second quarters and quite possibly the third, making this recession the longest since the Great Depression. Based on the most recent Wall Street Journal consensus forecast the US economy is likely to contract by 3.0% from peak to trough – making it one of the most severe recessions in recent history. By comparison the 1974/75 and 1980/82 recessions saw peak to trough contractions of 3.1% and 2.2% respectively. An alternative, and worst case scenario, would be a 4.5% contraction as indicated by a recently published study by the IMF showing economic recessions preceded by “financial stresses” are more severe than those not impacted by turmoil in the financial system. Our baseline scenario sees job losses continuing through 2009 with only modest gains in 2010. On a relative basis, job losses will exceed both the 1974/75 and 1980 recessions.

The Office Leasing Market
With the above backdrop we expect the US office market to contract by 3.0%. This equates to 125 million square feet (MSF). From the peak of the market, occupied space has already contracted by 15 MSF, leaving a further 110 MSF. Most of this negative absorption will be experienced in 2009 with approximately 25 MSF per quarter with the balance in early 2010. The worst case scenario would see occupied space contract by 187 MSF. To put these numbers in context, the office market downturn during the 2001-2003 period contracted by 120 MSF. For local markets, most can expect occupied space to also contract by 3.0%. However, markets highly skewed towards financial services such as Manhattan and San Francisco will mostly likely contract by 6.0% and in a worst case scenario 9.0%. At 9.0%, Manhattan negative absorption would total 34.0 MSF and San Francisco 6.6 MSF.

Financial Services Employment (Percent of total employment)
Select Major Markets
Atlanta 6.2%
Boston 7.6%
Chicago 7.7%
Dallas/Ft. Worth 8.0%
Denver 7.4%
Houston 5.6%
Los Angeles 5.2%
Manhattan 10.7%
Philadelphia 7.6%
San Francisco 9.5%
Seattle 6.4%
Washington 4.9%
US Average 5.9%
Source: BLS

Absorption

Source: Colliers Research

Office Rents
Despite modest new construction in the next year, office vacancies are expected to rise by six percentage points to 20% by the end of 2009 which will put significant downward pressure on office rents. Downtown office rents are expected to fall by 25% (peak to trough) while suburban rents will fall a more modest 15%. These declines are similar to those experienced earlier this decade, although the national vacancy rate topped out at 16.5% and not 20% as indicated above. Local markets are expected to register declines above and below the national averages depending on construction, exposure to the financial services sector and the level of sublease space. Markets with heightened levels of any of these characteristics can expect rents to fall an additional 5%.

Office Rents
Source: Colliers Research

There is no disputing the outlook for office building owners is grim. Even the base scenario has building occupancy rates falling below 80%. This recession will be without doubt the longest since the Second World War and quite possibly the deepest. There will be markets that perform better (and worse) than the national average but with all parts of the country, and indeed the globe, reporting sluggish economic conditions none will escape the current downturn. The good news is that the economy will be on the mend later this year but not until after suffering a very large setback and in particular a job market that will not show any signs of robust growth in 2009 even with the benefits of the just announced stimulus package. Landlords will be faced with a very challenging leasing environment while tenants that have leases expiring will reap the benefits of 2002/06 era rents. Timing the bottom will be difficult but all indications are rents will decline most of 2009 and possibly into 2010.

Ross Moore
Executive Vice President, Research
Colliers International USA

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