THE UNITED STATES OFFICE MARKET RECOVERY IS FACING HEADWINDS

04/29/2011 10:57

The National Bureau of Economic Research officially announced that the greatest economic downturn in the United States since the Great Depression ended in June 2009, almost 24 months ago. The recovery has been painfully slow, but over the past two quarters we have seen signs that the economy is finally gaining sound and sustainable traction. The country is now starting to add jobs; indeed, last month, the nation added over 200,000 new jobs to the economy. The four-week moving average of first-time unemployment claims has finally dipped below 400,000 applicants, the target threshold many experts believe to signal a strengthening labor market. The jobless rate actually fell in 75.0% of the 372 largest metropolitan areas from January to February. The manufacturing sector is expanding at its highest rate in years and corporations have reported strong corporate profits for the past four quarters. In fact, first quarter 2011 earnings for many major corporations, who have reported so far, have already exceeded analysts’ estimates. Further, retail sales are up year-over-year and auto sales are starting to return to pre-recession levels. Office Market Still Remains Sluggish Given all this good news, why are we not seeing tangible signs of improvement in the United States office market? Today, the national office vacancy rate remains in the mid-teens and has been stuck there for quite sometime. Indeed, there are office markets that are out-performing the national average, including New York City and Washington DC., but these are few and far between. So what is the problem? First, if there is one thing that corporate America learns during a recession, it is how to do more with less, which includes both employees and the space they occupy. Recent research has shown that corporations are packing more people into less space; this is a structural change that is occurring in the industry, meaning that it is becoming a permanent part of the office demand equation. The old rule of thumb of assuming 200 square feet of office space is required to house each employee is simply not the norm today. In fact, research has shown that in some markets it is probably safer to assume a ratio closer to 160 square feet, a 20.0% reduction from the “norm.” Firms are designing their space to maximize density, without (they hope) sacrificing productivity. Upon a recent visit to the headquarters of a major professional services firm, one could observe this trend. Private offices are being shared, through a “hotel-ing” process, by several managing directors; managers no longer have exclusive use of an office; they must now “reserve” space, very similar to reserving a room at a hotel. Just to illustrate how far companies will go to maximize the use of their space, at this particular location, window sills were being set up as work space for analysts—a unique concept. Second, many companies have a lot of under-utilized space, as a result of downsizing during the recession. No one really knows for sure exactly how much space fits into this category, but it is most likely quite substantial. Obviously, firms are first going to satisfy their expansion needs by using existing space before committing to new space. Third, the economic base and the historic drivers of office demand in many markets have been turned upside down since the beginning of the recession. Take Charlotte, North Carolina for example. For years, the growth of the office market, particularly in downtown Charlotte, was linked to the explosive growth of the banking and financial services sector. The landscape has certainly changed today, as a result of mergers and acquisitions within these sectors; citing the acquisition of Wachovia Bank by Wells Fargo as just one example. Prior to the financial crisis, downtown Charlotte had one of the lowest vacancy rates in the country, less than 3.0%; today, the vacancy rate downtown exceeds 10.0%. The same story could be told regarding other metropolitan areas in the United States as well; many need to “reinvent” themselves to become attractive to a more diversified group of industries. The point is that this will take time, further slowing the office market recovery in select metropolitan areas. Small Businesses Grapple with Demand for Goods and Services Fourth, small businesses—companies with less than 500 employees—are the backbone of this economy. Since the beginning of the recovery, and until just recently, small businesses were not optimistic about the near-term outlook for their firms; given this uncertainty, they were reticent to bring on more employees and less willing to expand their physical plant. Contrary to popular belief, small businesses have not been expanding due to the lack of financing (although this may have been true in some cases); more importantly, they were not, until just recently, witnessing a tangible increase in demand for their goods and services. Companies put Expansion Plans on Hold Fifth, companies only lease new space when they are confident about the future outlook for their businesses. As we noted above, many experts firmly believe that the United States is on a path to a sustainable economic recovery. Nevertheless, the economy is facing headwinds that could be giving many companies pause for thought regarding their plans to take additional office space in the near future. What are they worried about? (A) The impact of rising commodity prices on global economic growth -- Inflation is a major concern today in emerging markets; China, for example, has been raising interest rates and requiring state run banks to raise reserves in order to slow growth and tame inflation. The fear is that any slowdown in the world’s second largest economy will negatively affect global economic growth, including the United States. (B) It is too early to gauge the overall impact that the earthquake and tsunami in Japan will have on the short- and mid-term outlook for economic growth in the United States; it will have an impact, the question is how much. (C) It is only a matter of time before interest rates rise in the United States following a period of historic low rates; the question is, when and by how much rates will rise and how this will impact future economic growth prospects of the United States. The point to be made is that many firms put “on hold” any expansion plans during times of economic uncertainty, until they have a clearer picture of what lies ahead. Conclusion In summary, it may simply take awhile before we see significant improvement in the overall performance of the United States office market. Indeed, select office markets such as New York should continue to fare well, but the majority of the office markets throughout the United States will probably not see significant improvement in the near- term future. On the other hand, one should not expect significant deterioration in office market conditions either; the worse should be behind us. Barring any unforeseen economic or natural calamity, many office markets should witness improving performance as we approach 2012; fortunately, there is very little speculative office development taking place throughout the United States, which will enhance the pace of recovery. In the near-term, rents will most likely remain stable and concessions will become a permanent part of the national landscape over the foreseeable future.