Cautious Optimism in Office Market

The GDP grew 1.2 % in the first quarter of 2008. Year-over-year inflation edged lower in April to 3.9 %. In April, core inflation – a more stable indicator because it factors out large monthly swings in food and energy prices – moved lower to 2.3 %. Stable core inflation may be the saving grace bolstering the sluggish U.S. economy, which has limited price increases outside the volatile food and energy sectors.

Unemployment edged down slightly to 5.0 % in April but the employment report did provide some optimism, revealing a manageable 20,000 job loss, a sign that the economy may face a shallow rather than severe recession. Some of the optimism stems from a sharp turnaround in the professional and business services sector. This sector is the largest component of the office-using segment.

Last week’s slight pullback on oil prices and better-than-expected GDP figures created positive momentum for real estate stocks, which were up 2.8% as they rallied with the NASDAQ (up 2.6%) and were ahead of the S&P 500 (1.7%) and S&P Utilities Index (1.5%).

Although the financial sector continues to drag down the broader markets, the office sector is maintaining some positive momentum. Last week, it marginally outperformed the WRESI, which gained 2.8 % during the past week. Year to date, the WRESI is up 9.4 %. For the week, office stocks moved up 2.9 %. SL Green Realty led the group by edging up 5.2 %.

For the quarter, office vacancies rose a less-than-expected 20 bps to 12.8 % nationally. Uncertainty in the economy has caused some tenants to delay large lease commitments and expansions. With that said, asking rents increased some 1.7 % in the first quarter. This occurred despite rising vacancies in certain challenged markets including South Florida, Orange County and Riverside-San Bernardino, Calif. Markets that experienced the most notable increases in rent growth included Boston, New York, Houston, and Dallas. Effective rents remain flat due to use of concessions. On a positive note however, sublease space is rising more slowly during this period, which is having less of an effect on office rents.

There continues to be bright spots on the horizon for the office sector. The national default rate on commercial mortgages is a slim 0.4%. Economists generally are in agreement that this downturn will be unlike previous events and most predict a shallow slowdown with a recovery beginning in the second half of 2008. During April, $4.9 billion of office investment transactions occurred, which was an increase from February, but still well below comparative levels in 2007.

Despite changes in the capital and debt markets, not all buyers are constrained by the debt markets or are waiting on the sidelines for prices to fall. Although many institutional investors have slowed their rate of investing, they actually have increased their share of all office acquisitions to 23% because so many other buyers are out of the market. It is anticipated that institutional buyers will help drive the recovery with offshore investors accounting for 12% of all recent office acquisitions.

We think the divergence with the debt markets reflects the reduction of hedges that were put in place earlier this year. As more banks sell off their commercial mortgages, the amount they need to hedge is reduced as well. This means that banks would be able to sell credit default swaps, buy REIT equities or purchase the CMBX index. What’s more, fund flows remain positive with $31 million flowing into domestic real estate funds and another $73 million into the global funds.

When the economy and credit markets have stabilized, we continue to believe that the Federal Reserve may shift gears and begin raising interest rates to combat inflation.