A tale of recovery.

The recovery of the U.S. office market is perhaps the biggest real estate story of 1995. Occupancy rates are rising nationwide. And some top-performing markets are blazing a trail that has left occupancy rates above 90 percent.

Something strange happened at the banquet this year.

* As usual, the elders of the respected Investment family hosted their annual grand banquet to honor the family's outstanding achievers. Of course, most offspring from the tribes of Stocks, Bonds and Mutual Funds were invited to the feast, along with other good sons, daughters and descendants. * But members of the estranged Real Estate branch of the family--especially Office--had been snubbed in recent years when it came time to dine. However, this year things were different. * Real Estate, with its sordid past (the building binge of the 1980s) had become the proverbial wart on the Investment family's nose. It had gone for years in the 1980s and 1990s without an invitation to the annual gathering. The Investment family simply could not reward a tribe that had led a life of such indulgence, building far more space than needed, reducing its worth to shameful levels. Real Estate, with this snubbing, was sent an ultimatum: Start taking responsibility for the space you've already created before bringing more into the world. * One by one, the households within the tribe of Real Estate began to respond. First, Apartments, followed by certain cousins in Industrial and Retail, embarked on a turnaround. Sure, several cousins remained delinquent, but progress was being made. * Slowest of all to turn around, however, was Office. This household was the most self-indulgent of the lot, registering occupancy rates in the 60 percent range among wayward cousins in Denver, Houston and Dallas. Cousins in California and the Northeast, ever overconfident, said that the fate that fell upon the lowly Southwest markets would never happen to them.

But, by now, the story of what happened is well known. Eventually, virtually every cousin in every city of the far-flung Office household experienced serious problems. Declines occurred in occupancies, rents and values. The nation's office construction binge did not slow in earnest until 1991--the year when the nation's occupancy rate hit a low of 81 percent.

All of which is why what happened at this year's banquet was startling. In 1995, people at the banquet gasped and turned their heads in amazement to see members of the Office household being admitted once again to the prestigious feast. Other members of the Real Estate tribe breathed a sigh of relief, while other tribes stared curiously, but gave reluctant acknowledgment to the returning prodigal son.

Office market rebounds

The recovery of the national office market is perhaps the biggest real estate story of 1995. The office market has been beaten and bruised but holds fast to a March 1995 national occupancy rate of 85 percent, evidence of its new lease on life.

The story of this rebound centers on the market forces that accounted for Office's exclusion and readmission to the Investment family's banquet. Yet, the recovery is neither complete nor consistent across the nation's major metropolitan markets. Notwithstanding these reminders to keep the good news in perspective, the national office market does in fact have good news to report.

The two leading property value indices--National Real Estate Index and Russell-NCREIF--both document that the office sector rounded the corner in 1994. The Russell--NCREIF office subindex registered a positive annual gain of 4.4 percent in 1994, following four years of negative readings.

The National Real Estate Index, which had tracked the decline of office sale prices for several years, also took a new direction in 1994. The price index rose 5.8 percent from fourth-quarter 1993 to fourth-quarter 1994 to just under $140 per square foot for Class A central business district (CBD) office buildings (the only category tracked by NREI).

The current national occupancy rate of 85 percent by itself cannot explain the renewed enthusiasm for the office market. Occupancy levels fell in the late 1980s and then languished around the 81 percent mark for several years. But in the current cycle, it was the cessation of office construction and renewed economic health that began the recuperation. Since June 1992, the nation's average occupancy rate has risen from 81 percent to 85 percent, according to CB Commercial (see Figure 1). U.S. office occupancy is rising and is well positioned to continue its upward climb.

[Figure 1 ILLUSTRATION OMITTED]

Class A product is a leader in the office market recovery. Occupancy rates in Class A space are typically a few percentage points higher than Class B occupancy and several points higher than Class C or D. The explanation for this is a flight-to-quality Lowered rents in Class A space attracted tenants that formerly opted for lesser-quality space.

Will the low occupancy of Class C and D space continue to drag down the overall occupancy rate? For a while, yes. However, the functional obsolescence of Class C and D buildings is so severe that many of these buildings will become virtually unmarketable. Eventually, the majority of lower quality buildings are expected to be removed from inventory because of acute irrelevance.

Since late 1993, a handful of metropolitan office markets have climbed above the 90 percent occupancy mark. The significance of each occurrence is enormous because it hastens the day (if not announces the arrival) of double-digit rent increases and speculative construction. Although that day remains far off for most markets, a select few are at the doorstep of justifying new construction.

Suburbs outperform CBD

A closer look at the occupancy trends reveals an interesting intra-urban fact: The national suburban occupancy rate surpassed the national downtown rate in early 1994. Throughout the building boom of the 1980s, downtown office markets retained significantly higher occupancy rates than suburban markets. However, the recovery has eroded this difference, as shown in Figure 2. From March 1992 to March 1995, downtown occupancy rates crept up by less than two points to 84 percent. But suburban occupancy leapt by more than five points to 85 percent.

[Figure 2 ILLUSTRATION OMITTED]

A variety of factors contributed to this trend. Central business districts actually have become less convenient than suburban locations. Ironically, the historical appeal of central business districts has been their "centralness." For years they have facilitated the efficient exchange of professional services at a place accessible to the labor force. But this efficiency, in many cities, has been replaced by friction and barriers that have reduced the appeal of downtown locations. Some of the factors eroding the appeal of downtown office sites are:

* Transportation and accessibility within the CBD and between the CBD and suburbs have not been developed at a pace to keep up with growing populations.

* The proximity of new residential developments often accommodates suburban office locations better than the more distant CBD.

* Occupancy costs in CBDs (e.g., higher CBD rents and land costs, higher CBD taxes, special CBD tenant fees, costly parking) have made the less-expensive suburban locations more appealing. Crime, or the perception of crime, has increased significantly in most CBDs and has made the suburban office market more attractive.

* High levels of CBD inventory were built according to older construction technology. Many of these buildings simply cannot accommodate the high power and wiring demands of today's computer networks without costly renovations. This fact and others make the renovation of newer suburban buildings or construction of build-to-suit facilities more appealing.

So are central business districts dead? Hardly. With an average national vacancy rate in the mid-teens, CBDs are clearly a preferred office location for many businesses. Furthermore, CBDs represent a tremendous investment of capital, politics and history that will not be abandoned. But given the negatives outlined above, the nation's CBDs must seriously address their problems if they are to compete with suburban locations.

Ups and downs 

On a national basis, rents began to rise in 1993 after falling in the late 1980s/early 1990s, then languishing for two years after that. Rents stabilized in 1993 and enjoyed a respectible increase in 1994. The National Real Estate Index, which monitors Class A pace in the downtown markets, posted a 6.3 percent increase last year, bringing CBD rents to $21.50 per square foot.

But even with this good news comes a dose of reality: effective rents remain anemic in nearly all U.S. markets and are still well below peak levels cached in the 1980s. So why the optimism? Because the spiral has found bottom in nearly all metro areas and, in some markets, rents are pushing upward. Furthermore rates in most metro markets have been rising for at least a years, positioning these markets for rental rate growth.

In the recent history of the U.S. office market, 1991 will be remembered as the year the bleeding stopped. The national office scene turned from crisis to recovery in 1991 because the brakes were finally put on construction.

Office building completions from 1986 to 1990 averaged 98 million square feet per year, according to CB Commercial. But in 1991, completions reached only half of this level (46 million square feet). And 1992 completions were nearly cut in half again to 28 million. A paltry 4 million square feet was built in both 1993 and 1994.

One of the "good-news" ironies in the office market is that rising occupancies, combined with other factors, led to increased build-to-suit construction activity in several metro areas. A lack of suitable blocks of contiguous space in existing structures and the lack of new multi-tenant construction to accommodate large users will continue to motivate further build-to-suit development.

So what expectations should we have regarding future levels of construction? Or, to put it more bluntly, "Have we learned our lesson from the 1980s?" Market evidence suggests the answer is, "yes." Today's new of office buildings are either significantly preleased or built-to-suit, meaning that new supply is being rationed strictly on the basis of demand. Furthermore, lenders are typically requiring more equity participation on the part of developers, who are now partners in risk.

These fundamental adjustments to the flow of new supply have brought control and accountability to the development process. Since the painful memories of the 1980s still sting, "control" and "accountability" will continue to be the watch-words applied to office construction volume for many years to come.

But beyond the volume of construction, what type of construction is expected for the remainder of this century? The next generation of office buildings will be very functional, without the pizzazz of the signature buildings of the 1970s and 1980s. Those architectural darlings could not be rebuilt today and command the rents needed for profitability. In today's business environment of cost cutting and resource efficiency, most tenants simply will not pay for the extra glamour.

Supply and demand

The key to the office market's current recovery is that net absorption, though slower than in previous years, is out pacing construction. In 1993, and 1994 especially, absorption outpaced new completions by a factor of 12. Consequently, occupancy rates made their greatest gains during these years.

Certainly office demand has gone through ups and downs. The year 1991 will not only be remembered as the year construction subsided--it's also the year that absorption subsided. From 1991 to 1994, annual absorption of office space averaged 42 million square feet per year, versus the 1986 to 1990 average of 71 million square feet.

While net office absorption in the early 1990s has not matched the levels of the late 1980s, it has improved in the past couple years. In 1993 and 1994, annual absorption for both years totaled roughly 50 million square feet, about 50 percent higher than the 32 million and 36 million square feet of office space absorbed in 1991 and 1992, respectively.

National economic growth, whether moderate or robust, should continue to create demand for office space through the end of the decade. And given a generally positive outlook for the U.S. economy over the decade (DRI-McGraw Hill projects an annual GDP growth rate of 2.5 percent for 1995 through 1999), office space demand will be a major positive force in the office arena.

On top of the effect that economic cycles place on office market demand, other factors exerting influence are secular changes in the national economic structure, corporate competition and culture, and international economics. All have direct implications for future office space use and space requirements. While some of the changes will be positive, the net effect of these trends will reduce office demand growth. Some estimates indicate that even with national economic growth in the 1990s comparable to that of the 1980s, total demand for office space will be only half that of the 1980s.

One of the most positive trends for office market demand is the ongoing realignment of the U.S. economy--the much-publicized shift from a manufacturing-oriented economy to a service-oriented economy. This shift bodes well for office demand because most office jobs come from the service sector, and service jobs are less likely to be exported to other countries than manufacturing jobs.

Another important positive trend for the office market is the growth of small-to medium-sized businesses. About two-thirds of national employment growth in recent years is attributed to small businesses, and much of the economic expansion in the United States forecast for the near term will be accounted for by small- to medium-sized companies. This trend alters the dynamics of office leasing and presents some good news for office demand in that small and medium-sized businesses typically occupy multi-tenant space rather than their own buildings.

On the negative side of the equation are several major categories of change that will have the net effect of creating much less office demand than existed in the 1980s. The categories are office demographics, corporate cost cutting and corporate downsizing, industry globalization and technological advances.

Two demographic phenomena already at play will reduce 1990s' office demand compared to that experienced in the 1980s. The demand for office space--moreover all real property--accelerated in the late 1970s and throughout the 1980s, as baby boomers entered the work force and as the percentage of working women increased. But today, even the youngest of the baby boomers (i.e., 30 years old) are fully assimilated into the work force, and the ratio of women in the work force has stabilized.

Another major influence on office demand is the current pervasive trend of cutting business costs. Costs have always been a key consideration to business owners but have taken on increased importance in recent years due largely to increased business competition.

Corporate downsizing has been one of the most negative influences on office space supply for several years. In many, if not most U.S. markets, corporate downsizing has placed large quantities of vacant sublet space on the multi-tenant market and has left many vacant single tenant facilities on the market. These latter structures often cannot be economically or functionally adapted for other office users. Although the latest wave of corporate downsizing appears to have slowed, corporations are likely to remain "lean and mean."

About two-thirds of national employment growth in recent years is attributed to small entrepreneurial businesses. This is leading to a demand for smaller spaces. Consequently, leasing agents will continually find that their bread-and-butter business will come from leases on small to midsized spaces.

The low-overhead operations of entrepreneurial companies are continually forcing large corporations to consider their bottom lines. Unlike any other time in history, service sector entrepreneurs have the same access to public information and productivity-enhancing technology as Fortune 500 companies. In effect, service sector entrepreneurs can produce the same quality work as a large corporation, but at a reduced cost and with a fraction of the overhead.

The priorities of corporate culture in the 1990s require less pizzazz and more functionality from office space than in the 1980s. Companies are less willing to pay for prestigious addresses, marbled lobbies and executive washrooms. In other words, the premier Class A product of the 1980s will not command the same rent premiums today. Similarly, companies are providing less office space per employee and the square-foot-per-office-worker ratio should continue to decline for the next few years.

Technological advances and globalization

Technological advances are altering the nature of office demand and reducing the overall level of demand in a variety of ways, including:

* Reducing manpower requirements. Examples of this type range from time-saving and error-reducing office technologies (e.g., spell-check and grammar-check on word processing programs) to task-repetition capabilities (e.g., computer-automated telephone messages). What's the newest gadget to hit the market? Voice-response word processor--just speak, and the computer will type documents for you. The impact on secretarial office space is obvious.

* Reducing space needs for equipment and fixtures. Today, a typical desktop personal computer has more data crunching capabilities than the mammoth mainframes used by the U.S. space program in the 1960s. The need for large multi-thousand square-foot computer rooms has virtually vanished. Also, computers have dramatically improved the efficient storage and retrieval of information. Corporate libraries, traditionally requiring an entire floor or more of Class A office space, can now be reduced to a personal computer and a handful of compact disks.

* Minimizing the importance of location. Improved technology has brought the advent of the "virtual office," allowing office workers to conduct their business in a variety of places other than the established office (home, hotels, satellite offices and the like), thus reducing space requirements for these workers in corporate offices. The virtual office has done nothing less than maximize the portability of skills, which has led to the trend of hotelling.

Just as its travel industry name-sake implies, hotelling is the practice of using office space on a short-term basis. The practice has been most notably used by large accounting and law firms that require certain employees to work in multiple locations. Just as in a hotel, employees are typically required to obtain advance reservations for the use of individual offices. And instead of being provided soap, towels and an ice bucket, employees are issued pens, paper, file trays and other office supplies that are turned in at check-out. Through the practice of hotelling, larger service companies are able to use space resources more efficiently, thereby reducing the amount of space required and overall occupancy costs.

Advances in technology, particularly in telecommunications, transportation and distribution systems, have paved the road for increased business globalization. And since certain business costs, particularly labor, are lower in other countries, many American companies are faced with the decision of relocating certain operations abroad. Ample examples of this exist in the industrial and manufacturing realm of real estate, but the effect on offices is significant as well. For example, Ireland has become a popular location for a number of U.S. data processing offices. But whether the number of office jobs sent abroad is many or few, global competition will continue to force executives to keep operating costs competitive.

As these trends concerning technology, globalization, downsizing and cost cutting affect office demand for the nation overall, they also have affected recovery in individual metropolitan markets. Although the market performance of individual metropolitan areas varies across the country, some patterns have emerged that characterize why certain areas are performing better than others.

Hot markets

CB Commercial's March 1995 occupancy statistics identify eight metropolitan markets among the major U.S. markets with occupancy rates of more than 90 percent. Five common features are represented by this group of markets.

* The majority (six out of eight) are second-tier markets--metro areas with fewer than 2 million people.

* Most of the metros are located in the nation's western and southern regions.

* Most of these metro markets are lower-cost business centers. Four markets--Salt Lake City, Las Vegas, Portland and Albuquerque--have benefited from the Southern California exodus, while Charlotte has been a major relocation market for companies leaving the Northeast and New England.

* Most of these markets possess at least one major internationally competitive characteristic. For San Francisco and Portland, the trump card is a Pacific Rim location. These markets, as well as Albuquerque and Salt Lake City, provide access to a multilingual labor force. Charlotte's emerging role as a major financial center helps its international competitive position.

* Most of these markets have an established or an emerging high-tech industry or high-tech communications infrastructure. Albuquerque, Portland and Salt Lake City all have attracted many computer-related firms over the past decade and provide a fertile climate for "smart company" growth. The Silicon Valley is the most visible high-tech component in the San Francisco region.

CB Commercial's statistics show the downtown sectors of Sacramento, Seattle and Boston to have office occupancy exceeding 90 percent. Also, the suburban of office markets of Austin, Minneapolis, St. Louis and Tucson have exceptionally high occupancy levels. These markets possess several of the characteristics just noted.

The top metros in Landauer's Momentum Index (based on best fundamental outlook) and MarketScore's rating (a measure of investment return potential) match well with the characteristics reviewed in CB's top-performing metro markets.

Many similar patterns also are evident in the metros with the best occupancy improvement. The 20 metro areas with a three-point or better occupancy increase in the year ending March 1995, based on CB Commercial data, also include a few markets that still have a tremendous oversupply of space, but they have assumed a rapid recovery pace.

These markets with fast-improving office occupancy numbers share the following traits:

* Nearly all of the 20 metro markets are midsized, second-tier markets.

* The six exceptions, markets with more than 2 million population (Denver, Atlanta, Boston, Dallas, Detroit and Tampa), are noteworthy. Three of them (Denver, Atlanta and Dallas) are major regional hubs, and regional hubs that are growing partially at the expense of older U.S. metro areas.

* Many of the metros serve as lower-cost business alternatives to larger markets.

* Several markets possess at least one major internationally competitive characteristic.

* The majority of the markets have an existing or emerging high-tech industry and/or communications infrastructure.

Which U.S. office markets will have competitive advantages in the 1990s? With less robust office-demand growth expected through the decade, relative to the 1980s, the following advantages will play an enhanced role:

* Metropolitan regions that are more advanced in technological and communications infrastructure, such as fiber-optic systems, have a competitive advantage. Most high-tech and telemarketing companies require the upgraded infrastructure for doing business.

* Metro markets with the best airline connections, for cargo as well as passengers, will have an advantage over metros with limited connections. The location of the permanent office is not as relevant as the ability to move the "virtual office" from one place to another.

* Metro areas that provide a quality work force at relatively lower wages will continue to attract companies from higher-cost markets and produce a conducive environment for expansions.

* Metros that can help keep down business costs (i.e., by keeping a lid on taxes and fees) will be more successful in attracting new business and cultivating business expansion.

* Markets with an educated, multilingual work force will have a competitive advantage over other metros as the global economy continues to increase in importance.

Office markets destined to be top performers in the years ahead will not just share one or two of these key traits. Office users will choose their locations for expansion or relocation based on the best balance of factors presented by each metro area. The most competitive and successful office markets over the coming years will be those making the best economic development strides in as many crucial areas as possible. So far, today's high-occupancy and most-improved occupancy markets have the best head start.

U.S. Office Construction & Absorption 1986 - 1994

[Figure 3 ILLUSTRATION OMITTED]

U.S. Office Construction

[Figure 4 ILLUSTRATION OMITTED]

FIGURE 5 Major Trends Affecting Office Demand

* + restructuring U.S. economy from manufacturing-based to service based economy.

* + growth of small and medium-sized companies.

* - office demographics: no more baby boomers to join workforce.

* - office demographics: stabilization of female labor participation.

* - business cost reductions.

* - technological advances: reduced personnel needs.

* - technological advance: declining importance of location.

Source: Holliday Fenoglio

FIGURE 6
Metropolitan Office Markets with
Occupancy Rates More Than 90%

Salt Lake City          93.8%
Columbus                92.8%
Albuquerque             92.6%
Portland                91.8%
Las Vegas               91.4%
Charlotte               90.7%
San Francisco           90.6%
Washington, D.C.        90.1%

Downtown Office Markets with
Occupancy Rates More Than 90%

Charlotte               94.6%
Columbus                93.9%
Salt Lake City          93.4%
Washington, D.C.        92.4%
Sacramento              91.7%
Seattle                 91.0%
San Francisco           90.8%
Boston                  90.4%
Portland                90.4%

Suburban Office Markets with
Occupancy Rates More Than 90%

Albuquerque             94.5%
Salt Lake City          94.4%
Portland                93.2%
Austin                  92.4%
Columbus                91.9%
Las Vegas               91.8%
St. Louis               91.1%
Minneapolis-St. Paul    90.8%
Tucson                  90.7%
San Francisco           90.3%

Source: CB Commercial, March 1995

FIGURE 7
Landauer's Momentum Index
for Top Office Markets

Salt Lake City          184
Portland                173
Charlotte               161
Austin                  154
Minneapolis             153
Nashville               141
Tampa                   132
Kansas City             128
Washington              127
San Antonio             125

Source: 1995 Landauer Real Estate Market Forecast. Median is 100.

FIGURE 8
MarketScore's Highest Potential
Return
CBD Office Markets

Market                Score

Columbus                93
Salt Lake City          93
Charlotte               92
Portland                92
Boston                  91
San Francisco           90
Minneapolis             89
Seattle                 89
Orlando                 88
Raleigh                 88

MarketScore's Highest Potential
Return
Suburban Office Markets

Market                Score

Raleigh                 97
Austin                  96
Salt Lake City          96
Las Vegas               95
Portland                95
Denver                  93
Kansas City             90
Minneapolis-St. Paul    90
San Francisco           90
St. Louis               90

Source: National Real Estate Index and Ernst & Young in MarketScore, Winter 1995.

FIGURE 9
Metropolitan Office Markets with 3+
Point Gain in Occupancy in Last Year

Tucson                  +6.1
Palm Beach County       +5.5
Stamford                +5.4
Ventura County          +5.3
Denver                  +5.1
Albuquerque             +4.9
Fort Lauderdale         +4.7
Salt Lake City          +4.1
Phoenix                 +4.0
Wilmington              +3.9
Fresno                  +3.6
Atlanta                 +3.4
Boston                  +3.3
Dallas                  +3.2
Bakersfield             +3.1
Detroit                 +3.1
Tampa                   +3.1
Austin                  +3.0
Oklahoma City           +3.0

Source: CB Commercial. Change from March 1994 to March 1995.

Michael C. Sobolik is assistant vice president and Jeanette I. Rice is senior vice president in the research and analysis department of Houston-based Holliday Fenoglio Dockerty & Gibson, Inc.