By Lynn Novelli

Limited new supply and strong demand kept office sector fundamentals strong in 2007, although stocks traded at appreciate discounts to net asset values. Bolstered by steady employment growth and stable interest rates, office REITs experienced healthy occupancy rates and rental growth.

"In particular, high barrier-to-entry markets, including Manhattan and West Los Angeles, were very strong, experiencing robust demand with limited new supply," says Ross Smotrich, senior managing director with Bear Stearns & Co. Manhattan, the largest and most significant real estate market in the United States, had the country's highest occupancy rates of 93 percent to 95 percent and rental growth reaching into double digits for the first half of 2007.

Looking beyond the powerhouse markets to second-tier suburban enclaves across the country, occupancy rates were in the high-80 percent to low-90 percent, and single-digit rental growth was positive, Smotrich says.

The Blackstone Group's historic $39 billion acquisition of Equity Office Properties Trust in early February 2007 helped set the tone for the first half of the year. Following the sale, the Equity Office effect impacted fundamentals sector-wide, says UBS office REIT analyst James Feldman. "As Blackstone sold some of its newly acquired assets, rents had to increase to meet the underwriting requirements," he says. "This contributed to a very positive environment over the next several months."

Shifting Metrics

The subprime lending situation and subsequent downturn in mortgage financing hit the office sector in the third quarter of 2007, leaving uncertainty in its wake. Hardest hit was Orange County, Calif., where a majority of the subprime lenders were headquartered. Vacancy rates soared to 13.3 percent by the third quarter, with predictions as high as 15.3 percent over the next two quarters.

In the aftermath of the immediate crisis, the office sector braced itself for a ripple effect on sector fundamentals nationwide. However, by the end of 2007, analysts were divided as to how drastic the negative impact would be.

On one side are those like Merrill Lynch analyst Steve Sakwa who believe the effects will be limited. "Mortgage companies that were occupying space in Orange County are no longer in existence," he says. "However, Manhattan has seen very little direct impact so far. There will be some job cuts, but there will not be a lot of sublet space coming on the market, because many of the banks affected were running lean and not taking up extra space."

Feldman is among the analysts on the other side of the aisle, predicting extensive further reductions in the head count of New York investment banks. This would likely produce declining demand for office space in New York City. To compound the problem, there are five projects breaking ground in midtown starting in late 2007 that need core tenants, he says. "However, the shock of the subprime mortgage situation has made people rethink how much they would pay for commercial real estate, and that has backed up all the way into real estate leasing."

Submarkets to See New Supply

Continuing the trend of recent years, supply was constrained in 2007 due to a combination of high construction costs, more stringent lending standards, and the lag between new construction starts and building occupancy. "On the macro level, inventory expansion has been fairly consistent at 2.5 percent to 2.7 percent of inventory for the past few years," says Deutsche Bank research analyst Louis Taylor. He called the expansion rate a "normal, absorbable pace."

However, Taylor cautions that the picture is very different at the local level. For example, Orlando, Phoenix and Tampa all will have new inventory of 6 percent available in the next two years. Washington, D.C. will expand by 4.5 percent. "Any time you see construction at 4 percent to 5 percent, it raises a yellow flag," he says.

Similar submarket differences are reflected in occupancy levels. At mid-year 2007, the national occupancy rate was 88 percent, a number skewed by the mid-90 percent occupancy rates in Boston, New York, Washington, D.C. and Los Angeles. Other markets, Taylor notes, have stubbornly high vacancy rates. He points to a 20 percent vacancy rate in Dallas, 15 percent vacancies in Atlanta and Denver and 16 percent in Chicago. "You have to drill down into the metro areas to understand what is going on with office REITs," he says.

Stifel, Nicolaus & Co. analyst John Guinee also anticipates an uptick in supply in 2008 in specific markets that will affect the sector's overall fundamentals. "On the macro level, there will be a slowdown in absorption, and occupancy will decline in almost all markets," he says.

Coupled with the slowdown in employment growth that began in the second half of 2007, "The net effect is that office REITs are less stable than they were in 2006," Sakwa says.

"There has been a correction in the market as people once again focus on fundamentals," he says. "Absorption will not be as robust and occupancy will flatten in 2008."

Positive Rental Growth

Rental growth was strong across the sector in 2007, reaching approximately 9.5 percent in the third quarter, compared with 5 percent for the same period in 2006 and 2 percent in 2005.

However, submarket differences persist, according to Green Street Advisors senior analyst Cedric Lachance. "Rental growth was superior on the coasts and just okay in the low barrier-to-entry markets," he says.

With new supply still several years away in the key high barrier-to-entry markets such as west Los Angeles, Seattle, Boston and New York City, office REITs in these markets should continue to enjoy good rental growth and solid NOI growth in the near term.

However, office REITs with properties in markets where the overall vacancy rate is high may find it difficult to achieve meaningful rent and NOI growth. Those with assets concentrated in low-barrier markets lack the growth potential of their peers with holdings in the markets where demand is strong.

"By the end of 2007, the overall pace of rental growth was decelerating. This, coupled with new supply coming outside of New York City, has a lot of people expecting rental growth to soften further in these markets into 2008," Lachance says.

Office REITs tend to lag the economy due to their long leases, so some analysts foresee that the slowdown in occupancy and rental growth will spread sector-wide in 2008 as the economy continues to decelerate.

Additionally, fallout from the subprime mortgage crisis in the form of foreclosures will continue to be heavy through at least the first half of 2008. "This has the potential to depress rental growth and increase vacancy rates in suburban markets as consumer products companies are affected," Taylor says, a development that would have widespread impact on the sector.

"On the positive side, the steady, slow climb in white collar employment bodes well overall for office REITs, as long as it continues," Smotrich says. In fact, there are legitimate concerns for 2008, but there still will be rental growth, Lachance adds.

On the whole, barring a push from a major deal like the Equity Office buyout, the slowing economy and the uncertainties of the debt markets mean that analysts look for office REITs to get off to a slower start in 2008 than in 2007.

Nonetheless, office REITs are still in demand by investors, Smotrich stresses. "We are still seeing a fairly decent demand to own investment quality office assets," he says, "from a universe that includes institutional and offshore investors."