On Friday, October 3rd, I spent several hours with the executive team of a privately-held financial services firm in New York.  It seems clear that – provided things don’t become much worse – the smaller, nimble, financially healthy firms are in a great position to take advantage of the recent economic events.  There is a wealth of talent “on the street” (quite literally), and these firms will be able to establish and grow new teams, groups, and divisions with relative ease through the next year or so.

With that shift in personnel comes along the shift in office space needs.  Large firms like Barclays (Lehman Brothers), JPMorgan Chase (Bear Stearns), Bank of America (Merrill Lynch), and others will be trimming their office portfolios drastically in the near future, from New York to San Francisco and everywhere between.  The smaller firms of today, who will be aquiring some of the new “free agents”, will be looking to add office space as well.  Still, between the frictional period and more efficent growth by small firms, we are undoubtedly up for a solid run of net negative absorption.  (Refresher definition: Negative absorption occurs when the quantity of space becoming available in the market (through lease terminations and new construction) exceeds the quantity of space being taken off the market (through new leases and renewals)).  Negative absorption, essentially, leads to increased vacancy rates.

In fact, also on Friday, Alex Frangos of The Wall Street Journal reported that:

Nationwide, rents on office properties — including landlord concessions and discounts — were flat in the third quarter, the worst result for office-property owners since late 2004 — when commercial real estate began to emerge from a prolonged slump, according to Reis Inc., a New York real-estate research firm.

Rent stagnation and increasing vacancies put “strain on borrowers to make payments on mortgages,” said Sam Chandan, Reis’s chief economist. “It hasn’t shown up yet in terms of delinquency rates, but this is clearly an issue we need to be very attentive to,” he said. Almost every type of financial institution, from community banks to Wall Street, lends to office-building owners.

The office market in suburban areas and smaller cities has been declining throughout the year. But now, with a recession looking inevitable, the pain is spreading to most large metropolitan areas. Previously immune cities such as San Francisco and Boston saw vacancy-rate increases in the third quarter. San Francisco’s vacancy rate rose 0.6 percentage point to 9.9% in the quarter. Boston’s rate rose 0.8 percentage point to 11.7%.

Of the 79 markets Reis tracks, vacancy rates increased in 66. Rents declined or were flat in 40.

- Frangos, Alex; “Office Space Is Emptying Out“; The Wall Street Journal; 03 Oct 2008; A2

It’s clear that negative absorption has already taken hold, and it will likely continue as the prevailing theme in office transactions for at least the next 9-18 months. 

While it is unfortunate for owners and landlords, increasing vacancy rates mean great opportunities for savvy tenants and corporate users.  The pendelum swings in this direction for about a year or two, every 5-8 years.  Now is the time to become increasingly proactive and aggressive about negotiating early lease renewals or extensions, and entering into new long-term leases.  Now is the time to push for higher tenant improvement allowances, and longer free/abated rent periods. 

Smart deals completed now will look even smarter in 3 years, and when it’s time to renew in 5 or 7, cyclical odds are that we may be in the next economic dip!