Demand is outstripping supply of Manhattan real estate.

Demand for commercial space is outstripping existing supply in the Manhattan real estate market - specifically large space users competing for limited supply. The strengthening of both the Downtown and Midtown markets is being spurred by a number of factors, including Wall Street's success, residential conversions, and the general lack of inventory.

Midtown Manhattan

The Midtown office market is the country's largest, with over 220 million square feet of space in 778 properties, 76 percent of which is considered Class A. Overall, leasing was strong, reaching 4.9 million square feet, 22 percent higher than the same period last year. Industries involved in the leasing activity included financial services, banking, insurance, law and several service industries.

The Grand Central, Madison/Fifth, Park Avenue and West Side submarkets all contributed to the high level of leasing activity. With one million square feet leased, the Grand Central submarket recorded the highest volume of year-to-date leasing, nearly 56 percent of which was completed by tenants committing to 10,000 square-foot blocks of space and larger. For the first time in 12 years, the Class A vacancy rate fell to single digits, at 9.5 percent. The Midtown Class B vacancy rate remained stable at 15.6%.

No other market demonstrates demand outstripping supply more than the Midtown market. High demand is driving the increase in rental rates. Total direct asking rental rates rose to $31.22 per square foot from $30.38 a year ago. Class A direct asking rental rates increased by $1.82 per square foot and ended the quarter at $37.03 per square foot. Class B and C direct asking rental rates remained stable at $22.72 and $12.73 per square foot, respectively.

All sizes of space types are in demand by tenants, particularly large blocks of space. Companies consolidating divisions and relocating headquarters are all prospective tenants of large blocks of space. Currently, there are 47 tenants with 100,000 square-foot space requirements in the market and only 32 blocks at this size actually available. This lack of large blocks of space has been the impetus for new construction such. as the Durst project.

As the market continues to tighten, this construction in Midtown will most likely continue. The redevelopment of the Times Square area and the development of Rock; West are two projects already on the horizon. The market's tightness has also encouraged owners to buy buildings.

Based on current market rents, these buildings (some largely vacant) are relatively expensive, but may prove to be good investments if the market continues its rapid improvement. A tight market not only instills competition among tenants, but also creates a more demanding landlord. Landlords are scaling back their concession packages. Improvement packages have decreased in the last year, as has the typical length of free rent. The net effective cost of leases is higher than it was only one year ago, confirming the fact that the market is moving further along the cycle from a tenant's market to a landlord's market.

The Midtown office market continued the pace of last year's recovery, showing signs of strength and improvement. Leases out in this market totaled nearly 2.1 million square feet, indicating that leasing activity could significantly accelerate in the months to come. As leasing remains strong and the availability of space tightens, rental rates will continue to climb as vacancy rates fall.

Downtown Manhattan

The Downtown office market got off to a very strong start in 1997. This can be explained by the decrease in supply and unchanging level of strong demand. With corporate tenants opting to maintain their Downtown presence and the Revitalization Program helping to remove a significant amount of product, the Downtown office market is poised for a dynamic future.

Leasing activity for the first quarter of the year was robust, with three major transactions completed, each over 50,000 square feet. Major sales included the purchase of 33 Maiden Lane and 90 Washington Street. Overall, leasing was relatively strong in the Class A market, amounting to 805,000 square feet, an 11.5 percent decrease over last year's figure. Although Class B properties slipped from 319,000 square feet of space leased last year to 298,000 square feet leased this year, the Class C market saw an increase of leased spare to 299,000 square feet from 179,000 last year.

Total direct rental rates decreased to $25.19 per square foot from last year's rate of $25.33 per square foot. Primarily due to the January, 1997 building reclassification, the Class A direct rental rate declined from $31.52 to $29.78 per square foot. Both Class B and C rates, however, experienced increases to $23.59 and $17.58 respectively,

While the overall outlook for the Downtown market is positive, certain submarkets were particularly strong. The Financial East district accounted for 51 percent of all leasing activity. The primary tenants were investment banks, securities firms, banks and more recently, technology firms. Unlike other submarkets within the Downtown market, the Financial East submarket experienced positive absorption of 305,000 square feet, a dramatic increase from last year's negative figure of 594,000 square feet. An important factor for this positive absorption rate was the fact that six of the 10 largest transactions for the quarter occurred in this district.

The current bull market is also driving the flurry of business activity in the Financial East submarket which, in turn, is necessitating the expansion of company facilities to service the increased business. Consequently, many companies are having to take on more physical space, as is the case with both Goldman Sachs and Morgan Stanley. Goldman Sachs committed to 93,794 square feet of space at Financial Square.

The increase in leasing activity is spurring the sales market Downtown. In many instances, the buildings are not bought as speculative office sites, but rather as potential conversions to residential or hotel facilities. Owners are capitalizing on the higher per square foot value of residential space, compared with that for commercial space.

These are all positive signs that the Downtown market has begun to recover after many years of decline. The Downtown Re-vitalization Program has undoubtedly helped the market regain some strength and, while the effects of residential conversions on vacancy rates are evident, the should begin to level off within the next nine to 12 months.