Deal or no deal? Owners holding all the cards.

Office market fundamentals continued to improve significantly during the first half of 2006, as the vacancy rate edged down and rents increased at a substantial pace.

The latter news is especially welcome, as it signals that owners are exercising a greater degree of pricing power than they were able to muster a year ago.

Indeed, leasing activity is chugging along, with several substantial space searches reportedly under way in the market, a task made more difficult by reduced availability of large spaces and a very thin construction pipeline.

Investors remain highly motivated to acquire properties in virtually every market in Manhattan. A diverse pool of buyers, including office property owners, redevelopment-oriented investors and residential conversion buyers, continue to push prices higher.

Conventional wisdom holds that rising interest rates will chill the for-sale housing market and, in turn, curtail conversion-related purchases of office buildings. The local market, however, often dictates its own rules, as there is always some level of unfulfilled demand for housing in Manhattan, raising the likelihood that conversion buyers will remain active this year.

However, if conversion buyers drastically reduce their purchases, other buyer groups may step up their activity. In fact, with space demand and rents improving, little new space coming online and many buildings occupying irreplaceable locations, a sustained high level of demand for Manhattan office assets is expected to persist in the months ahead.

Strong job growth is bolstering operating fundamentals in the city. By year-end, employers will add 33,000 jobs this year, a 1.4 percent increase. Included in the total are 20,000 office-using positions, representing a 2.3 percent gain over last year's figures.

In particular, leasing activity is gaining momentum in Lower Manhattan. The submarket got a lift in the second quarter as Moody's Investors Service inked a 20-year lease for 600,000 square feet at the 1.7 million square foot 7 World Trade Center. The office vacancy rate in Manhattan is forecast to decline 80 basis points to 8.6% in 2006.

New supply is not keeping pace with demand growth. Builders will complete 2.1 million square feet by the end of 2006, representing less than a 1 percent gain in stock. Approximately 1.7 million square feet is attributable to 7 World Trade Center, which opened in the second quarter.

As for office rents, robust demand will underpin a 9.5% increase in asking rents and a 10.2% gain in effective rents by year end to $48.48 psf and $41.71 psf, respectively.

Transaction velocity has declined 6% over the past year following an increase of more than 50% in the preceding 12-month period. Velocity has fallen at all price points, but the number of deals pricing for $50 million and more has slowed by 22% during the past 12 months.

Over the past year, the median price per square foot has climbed 25% to $416, but the rate of appreciation appears to be slowing, as the year-over-year median price was up 35% in January 2006. Cap rates range from 5.0% to 5.7%, down nearly 60 basis points from one year ago. Large Class A assets can price in the 4% range. Cap rates are expected to rise slightly during the remainder of the year, and the rate of price appreciation will continue to slow. For large Class A assets, prices may still climb a little as deep-pocketed investors seek to expand their local office portfolios.

The stock of medical office properties in Manhattan measures 4.4 million square feet. Although no major new projects are in the planning stages, medical office properties have attracted increasing amounts of attention from investors. Overall medical office vacancy of 4.7% in the second quarter is unchanged from year-end 2005 and 40 basis points higher than the rate in the first quarter.

In the second quarter of 2005, medical office vacancy reached 6.9%. Asking rents for medical office properties in Manhattan currently stand at $42.83 per square foot, a decline from year-end 2005. There are few sales of medical office properties in Manhattan, and properties in the outer boroughs typically attract more attention from investors. The median price of medical office properties in the Bronx, Brooklyn and Queens rose 12 percent during the past 12 months to $319 per square foot.

Operating fundamentals will remain strong as the year comes to a close. Supply growth remains limited, while office employment growth is solid and could exceed initial forecasts. Key space demand sectors such as financial activities are performing well, and employers may accelerate the pace of hiring.

BY MITCHELL R. LABAR, SENIOR VICE PRESIDENT AND MANAGING DIRECTOR, MARCUS & MILLICHAP