Despite Sluggish Economy, U.S. Office Sector Tightens in Prime Markets

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According to Jones Lang LaSalle's Mid-Year 2011 National Office Occupier Outlook report, the U.S. office market continues to tighten, though demand is highly segmented by product type and geography as the flight to quality continues. In light of economic turbulence, occupiers are placing more and more emphasis on strategies that enhance the flexibility and real estate productivity to meet rapid changes in the market.

"Increased office space demand, though highly varied across industries, geographies and product types, is placing pressure on corporate occupiers to execute transactions now to either accommodate growth or seize upon remaining market leverage since the ability to lock in favorable terms may become more difficult," said Tod Lickerman, CEO of Corporate Solutions at Jones Lang LaSalle. "Regardless of where the economic needle moves in the next six to 12 months, corporate real estate executives will continue to implement strategies that achieve cost savings, mitigate risk, shed surplus space and increase utilization rates."

Since peaking in mid-year 2010, the level of choice in the U.S. market has slowly edged downward. The flight to quality continues, evidenced by strong leasing activity in Class A product which caused the overall vacancy rate to decline from 18.4 to 18.1 percent in the second quarter.

Occupiers are more active this year, sensing that the timeframe to negotiate favorable lease terms is expiring. Year-to-date, 14 million square feet has been absorbed. However, while competition to lease space is up compared to 2010, it is still depressed from a historical perspective.

Occupier demand accelerated in most U.S. markets, with 73 percent of the markets we track registering a decline in the number of space options.

The spread between availability of premiere CBD space versus suburban space and between Class A and Class B product is showing even higher discrepancies than last quarter. At the end of the second quarter, the CBD vacancy rate was 15.0 percent compared to the suburban rate of 20.0 percent on a national basis.

Average asking rents held steady in the second quarter at $27.42 per square foot, indicating a bottom of the market from a pricing perspective. The asking rent has ebbed up and down within 1.0 percent over the last five quarters, indicating that landlords have put the brakes on widespread rent cuts.

The U.S. vacancy rate dipped from 18.4 percent in the first quarter to 18.1 percent in the second quarter, with 73 percent of the markets tracked registering a decline in space options. Recent high-profile transactions include Groupon expanding by 220,000 square feet in Chicago; Celgene growing by 92,000 square feet in New Jersey; Cliff Natural Resources expanding by 110,000 square feet in Cleveland; and Capital One Bank expanding by 135,000 square feet in Richmond.

The lowest vacancy rates were posted in New York City's Midtown South (6.7 percent) and San Francisco's South of Market submarket (6.9 percent). Conversely, vacancy rates were highest in Cleveland (24.0 percent), Sacramento (22.4 percent) and Palm Beach County (26.3 percent).

The spread between availability of premiere CBD space versus suburban space and between Class A and Class B product is showing even higher discrepancies than last quarter.  At the end of the second quarter, the CBD vacancy rate was 15.0 percent compared to the suburban rate of 20.0 percent on a national basis.

"Occupiers are leaving behind older, less efficient space and outdated suburban campuses for the open layouts of modern buildings in core urban areas," said Kenneth Rudy, International Director, Corporate Solutions at Jones Lang LaSalle. "These pockets of the market enable companies to tap into a broader talent pool and be on the leading-edge of innovation, a non-negotiable competitive advantage in today's market."

Competition to lease space intensified in the second quarter with nearly 11 million square feet of absorption, the highest level since the end of 2007, and significantly higher than the 4.3 million square feet absorbed in the first quarter. Though occupiers are more active this year, absorption is still not at levels that would signify a robust economic recovery.

"Though many leading market segments are now seeing the availability of premier quality Class A space tighten, the stalling economy has undoubtedly increased uncertainty and pushed some companies to delay large-scale capital decisions," said Lauren Picariello, Vice President of Occupier Research for Jones Lang LaSalle. "In addition, many occupiers with leases expiring in 2011 and 2012 wisely completed extensions at the market's bottom in 2009 and early 2010 to leverage discounted rates, so near-term roll on leases is smaller than average."

Average asking rents held steady in the second quarter at $27.42 per square foot, indicating a bottom of the market from a pricing perspective. The asking rent has ebbed up and down within 1.0 percent over the last five quarters, indicating that landlords have put the brakes on widespread rent cuts. Concessions are following suit, with both free rent and tenant improvement allowances ending the second quarter more than 10.0 percent below the peak levels of 2010.

Pricing continues to be highly segmented by geography; the national CBD average rent increased 1.6 percent, while the suburban average rent declined 1.0 percent since the end of 2010. Rent growth is particularly strong in coastal markets like the San Francisco Bay area, New York City, Washington D.C., and Boston. Rents also ticked upward in Texan markets due to expansion in commodity industries. Markets with strong concentrations in high-growth sectors such as high tech, biotechnology, energy and financial service are also seeing tightening.

"A recent analysis of the most expensive office streets in the nation revealed that these in-demand locations are 43.5 percent costlier than the national average," said Picariello. "This leaves occupiers seeking top-floor view space in tight tenant niche markets with limited negotiating leverage as landlords benefit from the increased demand for top-tier product."

The other factor limiting the amount of choice occupiers have in the leasing market is the highly constrained development pipeline. At the end of June, there was just 18.9 million square feet of office inventory under construction, representing less than 0.1 percent of total stock. The lack of development will be a challenge for those companies looking to secure large blocks of space in newly built, more efficient buildings. It may also tighten the timeframe occupiers have to transact and give landlords stronger negotiating power in late 2013 and early 2014.

Today's market realities are putting pressure on companies to cut costs without sacrificing productivity. Workplace mobility has become the go-to strategy for corporate real estate departments as they develop strategies to support the business through a more productive workforce.

"While workplace mobility is not new, advanced technologies, the impact of the millennial generation on Corporate America and challenging economic conditions have come together to push it to the top of the C-Suite agenda," said Rudy. "Looking ahead, workplace strategies such as desk sharing, work-from-home opportunities, and open space layouts will become the new normal as companies realize not only bottom-line savings but increased employee productivity, enhanced talent attraction and retention, increased space efficiency and energy savings."

The mindset that emerged from the global financial crisis of maximizing occupancy rates and creating lean, more efficient real estate solutions is now becoming more widely embraced. However, considering that utilization rates can average 60.0 percent, there is clear room for improvement in how companies use space.

Recent rightsizing has led to reduced footprints and smaller square feet per employee allocations. This trend will continue as occupiers look to avoid cost, reduce risk and use space more effectively, creating more productive, dense and cost-efficient office space.

The turmoil in the economy will continue to push many occupiers to scrutinize the productive use of real estate and enhance the flexibility of their portfolios to meet rapid changes in the market. A step change in leasing conditions is possible if there is a further slowdown in the economic recovery and landlords of top-tier product are forced to pull back on rental rates, but at this time it appears the market stay on its current course of steady - if slightly stunted - growth. Over the second half of the year, demand for office space will likely be slower, but not negative, and remain highly uneven across markets and product types. As the market tightens the ability to lock in favorable terms may become more difficult.