Stock market decline and US attacks encourage sub-leased offices

The stock market decline of the past 18 months has exposed many tales of corporate excess - and the sad story of America's sub-leased offices is among them.

Across the US, fully-fitted, often newly-built offices stand empty, as cash-strapped corporate tenants attempt to offload excess space into a falling market. They are a grim reminder of a time when budgets allowed for expansion of staff, rather than lay-offs, and scarcity rather than glut was the main worry for corporate real estate planners.

Torto Wheaton Research estimates that the amount of occupied office space shrank by an unprecedented 29.9 million sq ft between January and June.

Much of that "negative net absorption", as industry jargon calls it, is due to the arrival on the market of vacant space, available for sub-leasing.

UBS Warburg says the dire leasing performance in the first half is inseparable from the over-exuberance of last year. As the bank's real estate investment trust (REIT) analysts put it in a report this week, landlords were guilty of "excess leasing in advance of anticipated (and in many cases unrealised) growth".

Green Street Advisors, the California firm that has analysed the sub-lease phenomenon, believes there is more sub-lease space to come, because job cuts announced in the second quarter have not yet filtered through to that market.

That is the bad news. But in other respects, the picture is not quite as gloomy as it might seem - at least for landlords and new tenants.

The space that the original tenants are trying to sub-lease is mostly of higher quality than the corners of old offices that companies have tried to sub-lease in the past.

New tenants' preference would still be for fresh space, unencumbered by awkward lease terms and lengths.

But many companies want to cut costs quickly, which means they are prepared to sub-lease at rents that undercut directly leased space in the same building.

"Now there's so much sub-lease space, a larger percentage of it is competitive," says John Lutzius of Green Street Advisors. Provided the original tenant is credit worthy, sub-leasing also puts a buffer between the landlord and the economic downturn. Owners that leased space at the peak of the market last year may be further insulated by the original tenants' guarantees - letters of credit, cash deposits and pre-paid rent.

The question now is whether the September 11th terrorist attacks will drive the US office rental market into a deeper decline.

According to UBS Warburg, the impact of the attacks may actually release some pent-up leasing activity.

In the real estate sector, as in other sectors in the US, many investors were undecided about whether the economy had narrowly avoided recession or was a bout to decline further. "Well, there has been a resolution to the direction of the economy," says UBS Warburg, "and it's down".

Although the conviction that the US is already in recession is likely to reduce overall demand for commercial space, the bank's REIT analysts argue that it will also bring owners and tenants off the fence.

Landlords who were holding out for higher rents may drop their prices to levels that attract previously undecided tenants. The acceleration of the decline in the US economy also ends any risk of oversupply.

"Recent events will clearly halt any new construction for the balance of this year and into 2002," the group says in an analysis of the implications of the September 11th attacks, published last week.

Even so, analysts agree it will take another 12 to 18 months before developments already under way are complete.

"We don't show a significant slowdown in new supply until 2002 - and in fact, the pace picks up in 2001," says Ross Moore, national director of research for Colliers International. Torto Wheaton estimates that the overall office vacancy rate for the US would rise by 1.1 percentage points to about 12 per cent by the end of this year, assuming that new space enters the market 50 per cent leased.

The impact on the office leasing market will be "tame compared to 1991", the group says, but it could still take until 2003 for the economy to recover and the space to be reabsorbed.

The particular impact of the attacks on the New York City market suggests there may also be hidden reserves of office space that recent surveys do not record.

Tenants displaced by the World Trade Centre disaster have picked up much of the available sub-leased space in the city and surrounding area.

But at the same time, analysts say some 8 million or 9 million sq ft of "phantom space" - offices that were vacant but not on the market - has become available since September 11th. Some estimate that there may actually be more office space available in New York now than there was before the attacks, despite the losses in the financial district and the pressure from companies seeking replacement accommodation. If companies around the country have been hanging on to unused space, it may indicate that they overestimated their need for space to a degree that is not reflected even in the gloomy first-half figures.