A front page article in the Wall Street Journal on October 5 was titled “Signs of Recovery for Office Market.”   However, the truth can be found in the details, some of which are also disclosed in the same article.  The national vacancy rate for office as of September 2010 inched up to 17.5%, the highest rate in 17 years, but still below the 1992 record of 18.7%.  The reasons for office markets continuing to weaken are many: In the last few years many businesses that held on to excess vacancy because they couldn’t sublet a portion of their space or expected they would begin hiring by this point are now realizing they may not increase staff for some time; and many firms are figuring out how to squeeze more workers into less space.  

Not surprisingly, rents are following the vacancy trend, down 12% from their high point in 2008. As those leases come due, the tenants are downsizing, making it easier to trade up to better space for the same or lower rent.   

How does this impact the psychology of office buyers? Buyers realize that declining rent rolls and growing vacancies in the non-competitive office buildings could cause those buildings to qualify as “under water,” meaning the values may be less than the outstanding loan balance, and the cash flow may not be enough to cover debt service.   A deteriorating property in a soft market may not be able to recover for five years, no matter how much capital you pour into the lobby. With many loans coming to maturity in the next several years, increasing numbers of landlords will face a day of reckoning they are not prepared to deal with, and lenders will be taking control of more buildings.   

However, paralleling the tenant’s flight to quality, investors with money to burn are placing large bets on the buildings they feel will lead the market, and will not be at risk of declining cash flows, even as market absorption remains slack.    

In New York City, this trend is seen in several 2010 transactions by SLGreen Realty Corp. They sold a 45% stake in 1221 Avenue of the Americas (McGraw Hill’s headquarters building) for $576 million, and the mid-block 93-year old 19 W 44th Street.  On the flip side, they “traded up” in their acquisitions of 125 Park Avenue on 42nd Street across from Grand Central Station, and 600 Lexington Avenue. The upside in 1221 6th was relatively capped out to 2020, but some large pending rolls in the two buildings they purchased on major thoroughfares offer significant upside potential. 

Another recent example of this trading up phenomena is occurring in downtown Boston, where Boston Properties has agreed in early October to buy John Hancock Tower for $930 million, an increase of $269 million over what the current owners paid at auction in March 2009. This property is also benefiting from a trade-up by tenants, including Bain Capital’s planned relocation of 208,000 SF there this year. 

This trading up by tenants is occurring in most major markets around the country, and the tier 1 office markets, like NYC, Boston, Los Angeles and San Francisco, are seeing the capital’s flight to quality in the large investment deals taking place in those markets. 

-Mark De Riemer

Mark T. De Riemer is Senior Managing Director of Investment Services at NAI Global New York City, and is a member of the Investment Services Group.