As employment goes so goes office vacancy rates...or does it? By Bob Canter, President, Performance Realty Solutions

Implications: From the source article...“The forward indicators of the labor market activity offer little hope that the labor market will be spared,” says Ken Goldstein, labor economist for The Conference Board. “It’s not good news when more people are signing up for unemployment checks, and the average length of unemployment is lengthening.” There will be some industries that will suffer more than others. Anything real estate and housing related is expected to take a hit as far as jobs, and that includes everything from mortgage companies to home appliance manufacturers. And today 1/8/08 from the Telegraph.UK... US recession is already here, warns Merrill...http://www.telegraph.co.uk/money/main.jhtml;jsessionid=VONGALVD1KVKVQFIQMGCFGGAVCBQUIV0?xml=/money/2008/01/07/bcnuseco107.xml  

Analysis:  There is no question that office vacancy rates are directly tied to the employment rate. How else can it be explained for example the New York City office market has been experiencing the lowest vacancy rate in the United States for several years? The reason is NYC has been a hot bed of growth was the financial sector, mainly due to the propagation of Hedge Funds and Wall St, along with the blistering real estate market both residential and commercial. It has fully recovered from the 2000 recession and 9-11-01. Don’t forget NYC lost approximately 10 million square feet due to the 9-11 tragedy. Companies scrambled to find new homes which automatically helped lower the vacancy rate.


The Washington DC downtown market which has experienced the 2nd lowest vacancy rate in the United States, because there  has been the lack of new construction, especially on a speculative basis, in both markets. Fast forward to the present, and as this writer has been barking for over a year that the wheels are about to come off due to the easy money the lenders practically threw at commercial real estate investors, coupled with the return of speculative new construction again due to lower lending standards for construction loans.


Its amazing how short the memory of lenders are, as it was just 15 years ago that the last commercial real estate disaster was coming to its conclusion. Never again we were told would construction loans be made for “spec” commercial buildings, or not unless there were 70%-80% pre-leasing commitments. Now we see 128 million square feet in two years that will have been built, mostly on a speculative basis.  


The DC market for example is looking at 16 million square feet of new, mostly speculative office construction. The reason is simple; it was due to the market’s historically low vacancy rate and spikes in rents.   Lenders historically will lend construction dollars into markets that show vacancy less than 10%. The thinking is there must be some portion of the existing office building stock that is obsolete, and the demand must be there, otherwise why else would the vacancy rate be so low. In addition, rents were spiking higher which made the increased cost of new construction worth the risk along with the fact that existing office buildings were trading at much higher levels than it would be to reproduce them. So far so good right? You can not blame the construction lenders on this particular issue...or can you?  


Of course you can, and the simple answer is a constrained market, meaning low vacancy, is better even if demand slips. You also can’t time markets, (as some within the commercial real estate community are finding out), and since downtown type office buildings take years to build from start to finish, you have to know from past experience those that start building at what should have been viewed as the peak or near peak of the market their timing was way off. The lenders disregarded every signpost that said stop look and listen. If you know that the market is at “Historically” low benchmarks vacancy wise, the only place for the vacancy rate to go is up. You have to know because as a lender you have experts and analysts that should be combing the data which they have access to, that can be empirically demonstrated to them. New spec construction means higher vacancy rates, period.  


So ironically you have lenders lending on 5%-6% cap rate investments (“historically” high sales prices) and lower in some classic high profile cases, due to low vacancy rate rationale and how stable the market is perceived. Equity players such as the pension funds and insurance companies jumped in to buy at these low cap rates...while at the same time out the other door they are lending for new construction, which anecdotally says you will create higher vacancy rates, which in turn should decrease the value of your investment as higher vacancy rates mean lower or at least flattening rent levels.  


So what went wrong besides the obvious? The part that went wrong is believing the hype that market rents were in an endless upward trajectory. Believing the United States economy would not be affected by the housing crisis, and lastly believing that there is no such thing as a business cycle. It was just this past summer that commercial real estate brokers were telling the tenants they represented to sign leases as quickly as possible to avoid the next rent spike...   In another Headline from yesterday’s WSJ an article is titled...” “Office Vacancy Rate Rises For First Time in 4 Years”...is there a coincidence? The article continues ...”Net absorption -- the change in the amount of occupied space -- dropped slightly below 4.4 million square feet in the fourth quarter. By contrast, 16.2 million square feet were absorbed in the previous quarter.” And lastly... “Even as tenants began to pull back on leasing in the fourth quarter, developers added more space to the market. More than 19 million square feet of new office space was completed -- the most since the fourth quarter of 2000, at the height of the last boom. This year, about 75 million square feet of new office space is scheduled to come online in the 79 markets Reis tracks, up from about 53 million square feet finished in 2007.” That is 128 million square feet in two years that will have been built!  


What has begun to happen is Corporate America has started lay-offs, due to declines in overall business, which has begun in many sectors. The first hit was the housing market collapse which has an enormous ripple effect. Now you have the financial sector laying off hundreds of thousands of workers. Just yesterday Citi Corp. announce it will be laying off 10% of its work force. Many other National Banks have already announced plans to layoff significant numbers of workers. Auto sales have slumped in an already weak automotive sector, which means more layoffs and the subsequent layoffs that will generate and that ripple effect.    


In addition small business owners will lay-off workers due to the change in the political climate towards business, when it becomes too expensive to keep them on. The politicians are already looking to cure the health insurance situation on the back of small business wanting them to be required to carry health insurance for their employees. Please remember, small business in the aggregate is much larger than big business and is the true economic engine of the United States.  


The only sector showing signs of life is the Health sector. The reason being is the rapidly approaching aging of the largest generation in United States history, the “Baby Boomers” In 2011 the group turns 65, three short years from now. Advances in telecommunications along high speed data and internet will allow workers to telecommute, and with the price of fuel, that alternative will be a very viable solution. Never mind how telecommuting reduces traffic congestion, pollution, and saves precious energy. If companies can reduce their physical footprint, especially in Cities such as NY & DC which have super high rent levels, why in world wouldn’t companies look to alternative solutions?    


Once again the commercial real estate community and the lenders have not looked at the all important demographics at play. They haven’t come to grips with the new paradigm emerging, or should it be said has been emerging. Outsourcing was the major concern a few years ago...does anyone realistically believe that has gone away?  


But there is a “But” the commercial brokers and owners will tell you...we have tenants signed up for long term leases, so we are insulated from unemployment trends. To some extent that is true; however, it will depend on how deep and far reaching the economic slow down becomes, since companies that go under don’t out live their leases or they stay afloat they don’t renew their leases. Its great if you have large publicly traded stable companies as all your tenants, but, how many office buildings are filled only with Triple A rated tenants...probably the same amount as those Triple “A” rated CMBS bonds that are out in the bond market going begging.  


You also have many buildings which were bought at such thin margins; in which the slightest vacancy will put their cash flow into negative territory... Or you have those that bought at the thinnest margins “banking” on the projected rent spikes that will never happen soon enough to keep them afloat.  


Please someone tell this audience how office vacancies are not destined to rise and why. Please explain where the demand will be coming from.


Its no different than the NAR Chief Economist saying there is pent-up demand for housing that will be evident in the second half of 2008 into 2009. That is a self serving ridiculous statement as it has no basis in reality. The same question must be asked of the NAR...where and how is this demand coming from? Is it coming from those that just lost their houses due to the sub-prime mess? Is it coming from low wage illegal immigrants? Is it coming from the aging Baby Boomers who will be looking to sell their homes to move into smaller places which require no hands-on maintenance and want to stash their equity for their retirement years?  Will it be the small Gen X & Y populations or perhaps the “Shadow Boomer” generation which is just now getting into the work force who are not traditional home buyers?    


It remains to be seen how deep this economic downturn cuts, but if history is any guide, as the famous Actress Betty Davis said in one of her movies...”fasten your seatbelts gentlemen ‘cause its going to be a very bumpy ride”...Keep your eye on the unemployment data and the rise in credit card delinquencies. The Federal Reserve can not bail out the economy...they will save the banking system from itself, but you won’t see any lending of significance going on for some time to come.


No lending means no business expansions and so on. Fasten your seatbelts....The New Paradigm has just begun. As Charles Darwin said...” It is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change." Commercial real estate et al does not adapt to change very quickly and resists it at all costs, especially the commercial real estate community et al.