New York and San Francisco Top U.S. Office Markets

A recent Wall Street Journal article ranked New York and San Francisco as the top two office markets in the country. Although both markets are expected to continue to see declines in overall vacancy this year, they are still viewed by institutional investors as the place to buy in 2007.

Many experts believe that the office market is being hyped more by speculation than by demand. Like the rest of the U.S. office market, actual demand has diminished from its high of 2005. Major markets throughout the United States have seen vacancy rates increase, including Los Angeles’s Orange County area and secondary office markets such as Indianapolis. In addition, office market ownership is shrinking as more and more properties are being purchased by large real estate investment trusts that have consolidated ownership in a number of cities, eliminating competition.

Markets such as New York and San Francisco, with vacancy rates less than 5%, are considered fully leased in terms of what appears on the books. As a result, owners feel no pressing need to lease remaining space at competitive rates. Instead, these spaces are being offered at higher-than-market rates because the real value will be based on the last deal done. Any uptick in rental rates will lead to higher value overall for these assets.

Most new owners of buildings have an 18–24 month reserve to cover small vacancies, so they have plenty of time to wait for a tenant who will pay the asking price, forcing tenants to pay high rental rates even though competition for these spaces may be far less than being touted.

For example, San Francisco has only 11 million square feet of possible leases expiring this year. This is considered slightly below average in terms of square footage in play, and it means that real net absorption must come from business growth.

San Francisco businesses are being hit with higher business taxes as well as higher parking and transportation costs, in addition to the higher rents. In April, parking rates in the city went up 20% as result of new parking taxes combined with increased parking costs as building owners seek parking revenue to match their office rental rate increases.

This will be a tough year for tenants, but they may win in the end. Landlords must realize that businesses that can’t afford to pay rent will look for options outside the city; right now, most businesses are not enjoying net profit growth proportionate to rental increases.