Tighter market brings changes to leasing scene.

There's no more free rent.

After several years when tenants could virtually name their price for office space, declining vacancy rates for these properties combined with a lack of new product is changing the deal structure for leasing.

Free rent concessions, offered as an incentive to lure new tenants for the past two years, is no longer on the table for most properties, and tenant improvement dollars are no longer as generous.

If trends hold, it is likely that rental rates too will start to climb mid-year, driven by the new market dynamics and the asking rates of the little bit of new property that is coming on the market.

"Construction costs have gone up considerably and prices are going up," said Jim Lindvall, a broker with Grubb & Ellis. "There's no question with the lack of availability and the cost of new development, I think we're going to be seeing considerable increases in rental rates in 2005."

So far, rental rates have merely stabilized. Leasing activity is still not strong enough to reverse the supply and demand ratio, which has heavily favored tenants in recent years.

But if job growth continues, even at the slow pace of 2004, it could shift the office market to the landlord's side, particularly since there are very few office buildings now under construction.

Already, with vacancy rates Valley-wide averaging 9 percent, brokers report that there are fewer choices for those that are in the market for new office space.

"Let's say you're a tenant looking for 9,000 or 10,000 square feet and you want to be in the Sherman Oaks marketplace," said Trevor Belden, a principal with Lee & Associates L.A. North/Ventura Inc. "You probably have two or three choices and one of those is a sublease. That's not a lot of choices for tenants. A year ago you probably had more like six."

Vacancy rates for the Valley slid to 8.8 percent in the fourth quarter of 2004, down from 12.8 percent in the same period of 2003, according to Grubb & Ellis.

For the 2004 year, the same report showed absorption rates (the total amount of space that was leased less the amount of space that was vacated) rose to 1.1 million square feet, up from 699,817 square feet in the 2003.

With that activity, rental rates have stabilized at an average of about $2.10 to $2.15 per square foot.

Asking rates do not always reflect the rate at which deals are made, particularly in weak real estate markets, and even at $2.15 per square foot, a rate higher than most deals came off at, those rates are still well below the averages for class A properties at the last strong real estate cycle early in the decade, when rents moved into the $2.25 per square foot range.

But what is likely to ease rents higher is a steep rise in construction costs that will push up the rates for new properties now under construction. As those properties come on line the higher rates will lift rates in older buildings as well, brokers and others believe.

Developments such as the one getting underway by Investment Development Services Inc. in Westlake Village and the latest properties under construction by M. David Paul & Associates in Burbank are expected to command rates of $2.75 per square foot.

As those buildings come online, brokers and landlords believe other properties will inch their rates up further.

"We're definitely bullish, and we expect rental rates to increase in the second half of the year," said Eric Hasserjian, first vice president at Arden Realty Inc. "If you look at the West Valley and Conejo Valley, there are probably more than one-half million square feet of requirements of 25,000 square feet and above, and you don't have that many buildings that can accommodate that."

Some submarkets, such as Burbank, have been slower to recover--vacancy rates there are still at nearly 13 percent levels. But in a number of other markets, even some that office tenants have traditionally considered less desirable, the improved climate is crimping the available space.

"North Hollywood has gone from 18 percent (vacancy) down to around 11 percent in the last 12 months," said Belden, who noted that the occupancy rate at one of the buildings he represents has risen to 70 percent from 35 percent in just six months.

'Product recession'

"On office and industrial, I'm confident we're entering a product recession," said Mike Tingus, senior vice president and managing principal at Lee & Associates. "Class B and class C is making up a majority of the vacancies. If you are a tenant in class B space and you want to move, it's hard to find class A properties. There's going to be pressure on rental rates because of the lack of space."

The single most important factor that will determine whether and how high rental rates will rise rests with job growth.

Right now, even those brokers who are betting on rent increases later in the year point out that the job recovery is not likely to be anything like what happened in the late 1990s, when the dotcom boom pushed the area into near full employment.

This recovery, they and others point out, is going to be far less dramatic. And, not to be overlooked, the office market is a lagging indicator, so space is not likely to fill up at the same rate that jobs are added to the local economy.

Still, there has been and continues to be improvement in the job market locally, and it is coming from a variety of sectors, another factor that bodes well for the future of rental rates, at least where landlords are concerned.

"Our job growth is good, but it's not the dotcom boom when things moved up fast," Hasserjian said. "I don't see anything like that happening, but jobs are growing steadily. We're seeing a real resurgence in production and studio requirement. So there's some good signs in the marketplace."