The U.S. office leasing market is beginning to crawl out of a deep hole. The rate of job creation in 2004, although muted by historic standards, may be enough to boost leasing activity. Landlords may follow suit by pulling some of their most generous concessions off of the table beginning in the second half of this year, suggesting that tenants should take action by mid-year to get their best deals. Nevertheless, tenants will wield negotiating clout at least through the end of 2005.

Asking rental rates will require several quarters — perhaps years — of falling vacancies before turning around. The recovery will be restrained on the supply side by the still-high inventory of sublease space and the unknown quantity of phantom space (empty space that is not being marketed), and on the demand side by high labor productivity, global outsourcing, rising healthcare costs that discourage hiring, and a labor force that will grow slowly compared to the 1990s as the giant Baby Boom generation passes into retirement. The office market will require 3 to 4 years of steady absorption and restrained construction to move from its year-end 2003 vacancy rate of 17.6 percent back to equilibrium, defined as 10 to 12 percent vacant.

In sharp contrast to the office leasing market, last year’s office investment market remained surprisingly firm, even robust, for leased, Class A properties with low rollover risk. Demand trailed off for properties further down the quality spectrum. Owners of riskier properties compensated for reduced rental income by refinancing their mortgages at lower rates, which kept a lid on distressed sales and foreclosures in 2003. The coming year is likely to bring a moderate increase in the number of troubled properties (poorly leased assets financed with variable rate mortgages or with balloon notes coming due) depending on how sharply interest rates rise and how slowly leasing activity improves.

Institutional investors are expected to be more active because they will face less competition for the top properties from private buyers armed with leverage. Value-added investors may step up their activity as troubled properties come to market.

Midwestern office markets have performed below average due to the high concentration of manufacturers present in the region. The manufacturing sector has hemorrhaged jobs at an alarming pace, losing 16 percent of its jobs since July 2000 versus a 2 percent decline in total non-farm employment during and after the 2001 recession. While manufacturing activity is associated with industrial space, manufacturers occupy office space as well, and downsizing actions often hit these facilities, turning them partially or wholly into surplus space.

Problems in the manufacturing sector also ripple through the regional economy, causing problems for service companies that do business with manufacturers. Fortunately the manufacturing sector is set to revive this year, aided by increased business capital spending and a weak dollar.

Traditionally, slow population growth has also negatively affected Midwestern office markets. Sluggish population growth translates into lower demand for office space from companies serving the local population, such as realtors, medical offices and small accounting firms.

Although the Midwest will not lead a national office market recovery in 2004, it will join the recovery sometime around mid-year, tentatively at first and with increasing vigor in 2005. Here are some key features for 16 primary and secondary markets throughout the region.

Chicago: Not since 1992 has the central business district (CBD) market been this soft. Space under construction totals 2.5 million square feet concentrated in the West Loop, with 60 percent of the space pre-leased. The suburban market has been hit hard by corporate downsizing, particularly from telecom firms including SBC, WorldCom and Motorola. While the Northwest suburbs have struggled, the O’Hare submarket lured tenants with newer Class A construction and proximity to the airport.

Cincinnati: As their leases expire, large CBD tenants will examine suburban alternatives. This will motivate downtown landlords and city officials to work hard at tenant retention. Although the market will remain soft this year, Class A product will find takers as evidenced by strong absorption at the Sawyer Point Building (CBD) and Centre Pointe (suburban).

Cleveland: More companies will take advantage of market conditions to shop their tenancy this year. The suburbs already are showing signs of improvement, led by the East submarket, anchored by Progressive Insurance, and the South submarket, where the Cleveland Clinic Foundation has been expanding.

Columbus, Ohio: Sublease and phantom space will drive rents lower in 2004, while continued downsizing will keep absorption in the red. Space remained on the market for an average of 20 months in 2003; this is not expected to improve in 2004. A market recovery worthy of the title will have to wait until 2005.

Des Moines, Iowa: Wells Fargo Mortgage is planning a 900,000-square-foot office park in the western suburbs, and Wells Fargo Financial is considering a major expansion in the CBD. Medical office and small build-to-suit projects will be hot this year. Both Iowa Health Systems and Mercy Health System are planning major medical facilities in the western suburbs.

Detroit: The strengthening economy has halted corporate bankruptcies and consolidations. The Interstate 96, Interstate 696 and Interstate 275 corridors stabilized in the second half of 2003. Landlord competition for large tenants is likely to remain brutal given the large amount of inventory in Southfield and Farmington Hills.

Grand Rapids, Michigan: After a decade of losing tenants to the suburbs, the CBD is gaining Blue Cross/Blue Shield of Michigan thanks to incentives from the city of Grand Rapids. East Paris and East Beltline are the most stable suburban markets. In nearby Muskegon, a new trans-lake ferry coincides with plans for a casino and renewed interest in downtown redevelopment.

Indianapolis: The dramatic rise in sublease space, totaling more than 1 million square feet, became the primary headline in 2003. The CBD performed better than it has in the past 3 years combined — thanks to leasing and sales activity from mid-sized firms. Market-wide rental rates and vacancies should hit bottom in the first quarter of 2004, but the rebound will be slow.

Kansas City: The market absorbed a robust 800,000 square feet in 2003, but deal velocity will not be enough to balance supply and demand in 2004. As a result, downward pressure on lease rates will continue. Downtown and South Johnson County should attract the most activity in the coming year, while the Plaza will remain the most stable.

Madison, Wisconsin: A state budget shortfall forced thousands of job cuts, contributing to an overall lack of demand that pushed asking rents down by 2.5 percent in 2003. About 50 percent of the 286,000 square feet under construction is pre-leased, which is much lower than average. Vacancy increased most dramatically in Madison’s largest submarket, Far West.

Milwaukee: Large users began several new projects in 2003 even as occupied space fell by 300,000 square feet. A recovery will not occur until tenants in the range of 5,000 square feet to 8,000 square feet, the bread and butter of this market, become active again. An impressive downtown resurgence is underway.

Minneapolis: The hardest hit area has been the Minneapolis CBD, where large corporate evacuations flooded the market with sublease space as new construction added inventory. One piece of good news: U.S. Bancorp struck a long-term deal to relocate up to 1,000 employees in downtown’s Pillsbury Center.

Omaha, Nebraska: Downtown is in the midst of a development boom that has created a new skyline and revitalized the riverfront while simultaneously stressing the market. Vacancy rates are likely to eclipse 30 percent by the end of the year. Vacancy also rose in the suburbs but, due to tame construction, it has leveled off and is poised to retreat.

St. Louis: The market is beginning to recover, partly fueled by tenants taking advantage of soft leasing rates to lock in long terms. Rates will stay flat through the middle of the year, possibly strengthening toward the end of the year. Tenants can find bargains in both the Downtown and West County areas, particularly along the Highway 40/Chesterfield corridor.

South Bend, Indiana: Tenants are committing to cheaper rents in solid, no-frills buildings. Typical concessions include free rent and above-standard tenant improvement allowances. In nearby Elkhart, a bright spot is the creation of an innovative downtown park that includes River Walk Commons, a new town center with pad sites available for office, retail and residential development.

Wichita, Kansas: Downtown, which has not seen significant development for more than 15 years, is getting a new law library, a 50,000-square-foot expansion by Excel and 400 new jobs at VeriPrime. The nearby Old Town area has a new multi-screen theater, while suburban development received a significant boost with four recent new tenant announcements led by the relocation of Commerce Bank and Foulston Siefkin Law Firm to the Waterfront development.

Robert Bach is national director of market analysis in the Northbrook, Illinois, office of Grubb & Ellis.

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