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Signs of Hard Times Lie Ahead For Real-Estate Market In 2002

Fallout From Sept. 11 Still Affects New York Office Market, Hotels


January 02, 2002

As 2001 began, all signs pointed toward an unusual and difficult year for the U.S. real-estate market. A year later, the signs are still there -- and there are more of them.

During the past year's economic slowdown, vacancy rates rose, market rents fell and, for the first time since such records were kept, tenants leased less office space than they did the year before. Then the attacks of Sept. 11 hit the real-estate industry at the center of its third-largest office market -- downtown Manhattan -- and the damage radiated outward across the country.

In whipsaw fashion, New York City vacancies immediately shrank under the weight of frantic new demand as tenants scrambled to find new quarters. But as the dire economic reality took hold, New York vacancies climbed back up and markets elsewhere further deteriorated.

Jacques Gordon, research director at the investment-management unit of Jones Lang LaSalle, a Chicago real-estate services and investment firm, says the national office vacancy rate was expected to settle at about 13.3% at year's end, up from 7.4% a year earlier and 12.3% at the end of the third quarter.

The deteriorating conditions for landlords created modest opportunities for tenants. Cushman & Wakefield Inc., a New York real-estate services firm, says Manhattan asking rents slipped to about $47 a square foot at the end of 2001 from about $51 a year earlier. Rents in San Francisco fell to about $46 a square foot from a peak of about $69.50 a year earlier.

The year was marked by two unusual trends. The slowdown in the economy forced corporations to put excess office space back on the market in unprecedented numbers: 266 million square feet, or 3.5% of the nation's 7.6 billion square feet of inventory, was put on the market as sublease space in 2001, says Steve Coyle, senior strategist for Property & Portfolio Research Inc., a Boston research firm. The sublease space made a meaningful contribution to rising vacancies, in contrast to the big real-estate bust of the early 1990s, when vacancies were caused mostly by overbuilding.

For property owners, a related -- and equally worrisome -- phenomenon was negative absorption. That means tenants occupied fewer square feet of office space in the first quarter of 2001 than in the fourth quarter of 2000, a first for the industry. Office demand shrank a few million square feet in the first quarter, then shrank at an accelerating pace through the next three quarters, leaving 48 million fewer square feet occupied in 2001 than in 2000, Mr. Coyle says. Compared with the 7.6 billion feet of total inventory, the number is small. But remember: Developers add supply all the time -- about 142 million square feet in 2001 -- never expecting that demand would ever actually diminish.

With those worrisome notes, here are areas that had an impact on the past year and seem poised to do so again in 2002.

New York's Woes

Most experts predicted earlier last year that the downturn for New York real estate would be relatively mild compared with the severe busts of the past.

But crystal balls were shattered by the collapse of the World Trade Center. Hotel vacancies skyrocketed, and Manhattan's perpetually high apartment rents began to fall. Huge questions were raised over whether the downtown financial district will ever fully recover from the devastation.

Shortly after the attacks, many expected the Manhattan office market to benefit from the destruction or damage to more than 30 million square feet of office space, a dramatic reduction in supply. But the opposite occurred. Available space in midtown Manhattan swelled to 16 million square feet in December from 12.8 million square feet in August, according to Insignia/ESG, a New York brokerage firm. Many corporations that lost offices had a surplus of space elsewhere in the region. Meantime, the recession and the fallout from Sept. 11 put pressure on other firms to cut back.

"The real-estate industry didn't recognize there was a tremendous overhang of softness within the larger financial-services firms," says M. Myers Mermel, chief executive of TenantWise.com, an online real-estate brokerage firm in New York.

Manhattan vacancies ultimately settled at 9.1% at the end of November, up from 8% on Sept. 11, according to a Merrill Lynch & Co. report.

The uncertainty has forced developers to shelve a wide range of plans. New York developer Douglas Durst says that before the attacks he was bullish enough on the city to move forward with a 50-story office tower on 42nd Street between Sixth and Seventh avenues without any preleasing. But now Mr. Durst says he won't start unless one-third of the building is leased.

Long range, much will depend on how quickly downtown can recover -- a political and financial challenge unparalleled in the city's history. City officials have been hoping for federal money to provide incentives to keep tenants from leaving and lure World Trade Center refugees back downtown. A comprehensive program has taken months to emerge, much to the distress of downtown's boosters.

Hotels' Misfortunes

Hotels were already suffering the most by the end of the summer, as companies sharply cut back on employee travel. Hotel fortunes then nose-dived after the attacks.

Compared with 2000, a very strong year for hotels, 2001 was dismal: The revenue-per-available-room rate, a main industry indicator, fell 8% for the hotel business overall, says Steve Kent, an analyst at Goldman Sachs Group Inc. The average industry occupancy rate fell to 59.4% from 63.7% in 2000.

With so much uncertainty, the market for hotels slowed dramatically. In the first half, some 67 hotels worth $10 million or more were acquired for a total price of $2.7 billion, up from sales of $2.3 billion in the first half of 2000, according to Hospitality Valuation Services Inc. of Mineola, N.Y. But in the second half, only 29 hotels were bought for a total of $1.1 billion, down from 69 for $2.4 billion a year earlier. Wyndham International Inc. had set a goal of disposing of $500 million in nonstrategic assets in 2001. But the Dallas-based hotel company is likely to sell less than half that, says Chief Investment Officer Joseph Champ. "After Sept. 11," he says, "it was too difficult to value the properties."

Tom McConnell, a senior managing director at Insignia/ESG, says 2002 will see more forced selling, with weakened hotel owners offering their properties at discount prices. Meanwhile, Bjorn Hanson, an analyst at PricewaterhouseCoopers in New York, says 8% to 15% of hotels won't generate enough cash to make their debt-service payments.

The silver lining: This downturn won't be as deep as that of the early 1990s, when hotels were saddled with high levels of debt, Mr. Hanson says. In 1990, he says, the average hotel was spending 14.1 cents of every dollar of revenue on debt service. Today, it's four cents on the dollar.

Dot-Com Implosion

The year provided a bit of revenge for tenants in high-tech markets who suffered during the boom years of the late 1990s, when vacancy rates shrank to below 3% and rents rose above $80 a square foot in some markets. With the dot-com implosion and severely curtailed technology spending by big companies, these same areas closed out 2001 with office vacancy rates as much as seven times higher, asking rents cut in half and concessions galore, including several months' free rent. Owners and investors of so-called telecom hotels -- buildings that house the equipment of telecommunications concerns -- were hit the hardest, with a nearly 40% overall vacancy rate, according to Grubb & Ellis Co., a New York real-estate services firm.

About one-third of the nearly two million layoffs announced by companies through November of last year were in the dot-com, telecom, computer and electronics sectors, according to Challenger, Gray & Christmas Inc., a Chicago outplacement firm.

"It was like a car hitting a brick wall at 100 miles an hour," says Rob Aigner, executive managing director at Colliers International Inc.'s Seattle office, describing what happened in Seattle's eastern suburbs and other markets dominated by dot-com, telecom and other technology firms.

Markets with a more-diversified tenant base, such as New York and even the Washington, D.C., area, didn't crash as hard as Austin, Boston, Denver, San Francisco, San Jose and Seattle.

Vulture investors circled these markets looking for deals, but the gap between offering and asking prices was wide, curtailing widespread sale activity. "Tenants who leased space in 2000 in high-profile technology markets and gave back space in 2001 continued to pay landlords rent," says Raymond Torto, managing director of Torto Wheaton Research in Boston, "and landlords continue to pay their debt" on properties.

Even after it became clear that tenants in tech markets ruled the day, many remained on the sidelines, speculating -- with good reason -- that even better deals are on the horizon for 2002. "The recovery will take a while," says Kenneth Rosen, chairman of Rosen Consulting Group LLC, a Berkeley, Calif., economic and real-estate advisory concern. But he predicts the technology-dominated real-estate markets should be the strongest markets by late 2003 or early 2004, with defense-related technology and biotech likely fueling growth.

Searching for a Haven

As the year opens, the area below Canal Street in downtown Manhattan is the most uncertain market in the U.S., and it will remain so for some time. Merrill Lynch's study forecasts vacancies there to reach 17% to 18% in 2002, well above the 8% to 9% rate expected for midtown Manhattan.

Bruce Mosler, Cushman & Wakefield's president of U.S. operations, doesn't believe downtown vacancies will go quite that high but says much depends on whether the government steps in to stabilize the area with subsidies for tenants or developers. "The city and state have failed to come up with a competitive incentive plan," he says, "and that failure will have a larger impact down the road."

Overall, U.S. real estate will be a reasonable haven for investors, with in-place leases protecting income through the current downturn, provided that it's short, forecasters say. Mr. Gordon, research director at the Jones Lang LaSalle unit, forecasts that major classes of real estate -- office, industrial, suburban and retail -- will provide returns of 7% to 9% a year as a group through 2003, compared with flat or negative growth widely predicted for the rest of the economy. Leasing is expected to be slow until the white-collar economy begins to turn around and companies use up the space they already have under lease.

Which sector will provide the safest of havens for owners is a matter of debate. Steve Sakwa, a top Merrill Lynch analyst, says the office sector is potentially the most problematic, adding that supply-and-demand data could be more unfavorable than expected when firms release annual results in February and March. He picks regional retail malls as best suited to provide strongest returns in a weak economy, saying the sector isn't as prone to overbuilding and stocks of retail companies appear undervalued relative to projected 2002 earnings.

Mike Kirby, an analyst at Green Street Advisors Inc., a Newport Beach, Calif., real-estate research firm, says retail is more likely to suffer later in a downturn as interest rates tick up and store closings accelerate in 2002. He and Mr. Gordon pick office properties as the safest bet, reasoning that the sector will be quicker than retail to respond too good economic news, such as rising employment.

Overall, real-estate professionals say, the industry should return from years of high growth from rising property values to its more traditional role of providing relatively safe income from leases. "It's a good defensive place to weather the storm," Mr. Gordon says.

Copyright 2002 Dow Jones & Company, Inc. All Rights Reserved.

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