Shifting Gears Concern about the potential impact of overbuilding on office market economics has been supplanted by worries about a falloff in the demand for office space. Does current market pricing already reflect that concern? by Barry Vinocur

Getting a handle on the demand side of the supply/ demand equation is important because of the ramifications a sharp falloff would have on office market economics. Though there's some disagreement as to whether the current pricing for office REITs already reflects the worst case demand scenario, no one argues that a sharp falloff in demand wouldn't have a very real impact on office market economics.

A falloff in demand would affect companies in a variety of ways. First, earnings models make a number of assumptions. For instance, by looking at current market rents, a company's average rents, and how much space is coming up for re-leasing, analysts project how much rental revenues will increase. That analysis goes out the window, however, if instead of rolling up, rents either don't increase as much as expected or stay flat.

How much of an impact a falloff in demand would have on a company's net operating income will vary depending on a number of factors, including how much space is scheduled to be re-leased in any given year, the company's current average rent per square foot vs. current market rents, and whether space can be re-leased to an existing tenant or a new tenant has to be found. Though analysts routinely build an allowance for re-tenanting space into their models, some investors worry that a significant decrease in demand might send leasing-related costs, such as allowances for tenant improvements (so-called TIs) and leasing commissions, through the roof.

Historical Absorption of Office Space   Historical Absorption of Office Space New Office Empl. Absorbed Square Feet (000's) Office Empl. Growth (%) 1980-92 240,750 64,751 3.7% 1978-87 302,600 69,450 5.1% 1988-97 228,000 43,720 2.6% 1993-97 353,400 43,569 4.0% 1978-97 252,667 53,891 3.7% Note: Data is the average for each period. Source: CB Commercial/Torto Wheaton Research; Prudential Securities

Again, it's an open question whether the impact of a sharp falloff in demand has already been reflected in the pricing of public office companies' shares. A number of analysts, investors, and even a number of office company CEOs recently told Realty Stock Review (Property's sister publication) that making that determination required "stress testing" the earnings models of every publicly traded office company. Said one CEO, "I know the analysts who follow our company have yet to redo their models to reflect any significant decrease in demand, so making a determination as to whether that falloff in demand is already reflected in our stock price would be difficult."

In a recent research report, Lou Taylor, who follows office companies for Prudential Securities in New York, and his colleague, J. David Kelsey, concluded that as of mid-July, the then current pricing for office companies already reflected worse than "a doomsday scenario." Since mid-July, the share prices of those companies have suffered a further significant erosion of their stock prices.

The question of whether current share prices already reflect worse than "a doomsday scenario" aside, everyone agrees that investors need to get a handle on office market dynamics. In their report, the Prudential analysts wrote that they believe the most reliable and consistent source of office data is Torto Wheaton, a Boston-based firm which is part of CB Commercial. Torto Wheaton has been aggregating supply and demand data for office space for 20 years.

A Leading Indicator of Net Absorption? Periods of strong demand in national office markets over the past 20 years have been prefaced by periods of falling occupied square feet per employee. On the national level, the strongest absorption years have been preceded by years in which occupied square feet per employee had approached or fallen below the 200-square-foot level. We believe that occupied square feet per employee may be a very good leading indicator of net absorption. Using this metric, there could be above average demand (that is, 43 million square feet) in the next two years. Applying our methods to the 20 largest markets, we conclude that Boston, Denver, Phoenix, and Seattle are markets with particularly strong pent-up demand," Prudential's Taylor and Kelsey stated in their report.

Torto Wheaton, the Prudential analysts reported, estimates that there is 2.3 billion square feet of office space in the 31 largest markets nationwide (the 54 markets tracked by the Boston-based firm have 2.7 billion square feet). For the past 10 years, the report continued, absorption has averaged 43.7 million square feet, or approximately 2.1% of the average office inventory (see table at left). With a base of 2.3 billion square feet, Taylor and Kelsey estimated "normalized" demand to be 48.3 million square feet annually, assuming a 2.1% demand factor. (Last year, Torto Wheaton estimated that there was 63 million square feet of demand in the 31 largest markets that it tracks.)

Torto Wheaton estimates that 17.5 million square feet of office space was completed last year. It forecasts 34.5 million square feet will be completed this year, followed by 46.6 million in 1999. The forecasted amounts would represent 1.5% and 2.0% of the office inventory, respectively.

How Elastic Is Demand?
With supply potentially increasing to 47 million square feet in 1999, investors could be justifiably concerned that a recession could hurt demand and the market could suffer severely, the Prudential analysts noted. However, they emphasized, demand is not solely driven by the number of new office jobs created.

Even when office jobs are contracting, they continued, leasing activity still takes place. "Zero job growth does not equal zero net absorption." During the early 1990s, when the economy was in recession and there was negative job growth, one might have expected to see a complete drop-off in office demand. Though demand did drop to 23.8 million square feet in 1991, the Prudential analysts pointed out, companies took advantage of the lower rents and took on additional space for future expansion needs. "We believe this demonstrates some elasticity of demand for office space."

As part of their analysis, Taylor and Kelsey looked at average office space per office employee. What they found was that it grew "noticeably" during the 1989-1992 period, from 203 square feet to 214 square feet per employee. During that period, average "asking rents" fell 8.4%. The average space per employee rose not as a result of falling employment levels, but rather due to increased absorption despite no employment growth. "Conversely, as rents have risen recently, up close to 18% from 1992, the average occupied square feet per employee has fallen to just 198." As rents rise, firms make decisions to maximize the use of their existing space in order to minimize rent costs. When rents fall, companies hoard space in order to lock in square footage for future growth, the Prudential analysts concluded.

"This suggests to us that there is still some pent-up demand in the marketplace, as well as the potential for firms to take more space per employee, much as they did in 1989 to 1992."