Office Rents Increase
As Demand Stays Cool

Demand for office space in the U.S. remained sluggish in the first quarter, a further indication that the office recovery is unevenly distributed and that rent increases may be due to moderate.

Rents in the nation's office buildings increased 2.8% on average in the first quarter, led by sharp jumps in the tight markets of New York and San Francisco, according to a survey of 79 large U.S. office markets excluding New Orleans by Reis Inc., a New York real-estate research firm. But demand for space continued to cool from the pace of early last year, barely keeping up with the still-restrained rate of new construction.

The rent jump was the biggest since the peak of the last office boom nearly seven years ago, but rents are a lagging indicator of an office market's health, says Lloyd Lynford, chief executive of Reis. "The car is moving really, really fast," he said, referring to the big rent jump. "But there's a question about how much gas remains in the tank."

That's because absorption -- the net gain in occupied space and the key barometer of demand -- was for the third straight quarter off the pace set when the office recovery began in earnest in the middle of 2004.

In the first quarter, tenants absorbed 10 million square feet of space, up from 8.1 million square feet in the previous quarter but well below the 15.7 million averaged from the third quarter of 2004 to the second quarter of 2006. Since then, absorption has averaged just 10 million square feet per quarter.

The slowdown in demand has slowed the declines in vacancy rates. In the first quarter, the vacancy rate edged down to 13.1% in the first quarter from 13.3%. That was helped by the restrained pace of new construction, which brought on 7.3 million square feet of space in the quarter.

But that could be the end of low supply. Reis projects developers will open 76 million square feet of new office space by the end of this year. That amount could put pressure on a vacancy rate that is still well above the 2000 low of 7.9%.

Demand for office space is directly linked to nonagricultural employment growth and companies' expectations about the economy. Mediocre job growth for the last several months has thus damped demand for new space.

While average office rents were up at a near-record pace in the quarter, the median increase in the 79 markets was far lower at 1.3%, signaling unevenness in a recovery that is tilted toward the coasts. Reis projects rents nationwide to rise on average 5% to 6% this year, down from 9% in 2006.

But in the tightest markets, rent increases are expected to be more robust. New York rents rocketed up 6.5% in the first quarter, while those in San Francisco were close behind at 5.6%. Of the top 10 rent increases, just two came from non-coastal cities: Houston and Austin, Texas.

The rental increases in New York are one reason the sales market there remains on fire. Just last week, 230 Park Avenue, known as the Helmsley Building, was bought by Anthony Westreich of Monday Properties and Goldman Sachs Group for $1.15 billion, giving the previous owners, Istithmar PJSC and Island Capital Group, a $400 million profit in 18 months.

"This island has become the wild, wild west," said Robert Emden, principal of PBS Realty Advisors LLC, referring to Manhattan.

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