Job cuts among financial and professional services firms will cause office fundamentals to weaken in Boston this year, but modest amounts of new construction will temper the supply and demand imbalance. With layoffs at State Street Bank, Bank of America, Merrill Lynch and Fidelity Investments projected to total in the thousands, a resulting decline in office space demand will drive up vacancy for the second consecutive year. In the CBD, negative net absorption of approximately 550,000 square feet will raise the average vacancy rate nearly 200 basis points to the high-11 percent range.
While tenant demand across the metro will wane in the near term, tighter construction financing and lingering economic concerns have reined in development activity. Completions in 2009 will drop off from last year and will represent only a 0.6 percent expansion of metrowide inventory, helping to offset reduced employment-generated demand. Weakening fundamentals and an uncertain economic outlook will underpin conservative buyer expectations this year. As a result, deals will be underwritten assuming higher vacancy rates and rent declines, elevating cap rates metrowide. Currently, initial yields are averaging in the high-6 percent to mid-7 percent range, up about 25 basis points to 50 basis points over the past year. Investment opportunities exist in the Back Bay/Fenway submarket, where Class B/C vacancy is around 10 percent and vacancy in top-tier assets is 6 percent. Buyers willing to reposition lower-tier buildings in the area could capture upside potential through higher rents when the market stabilizes.
Sales activity has been slowed by uncertainty surrounding price discovery, particularly in the $20 million-plus price segment. As more distressed assets enter the market, floor-level pricing will become apparent, making it easier to establish values for stabilized properties. The decline in the stock market has altered allocations of real estate in many investment portfolios, which could create some buying opportunities if pension funds and institutions sell real estate assets to improve liquidity.
Unlike past cycles, overbuilding is not the major cause of the current downturn. Nationally, office deliveries are forecast to total 51 million square feet in 2009, following the completion of 58 million square feet last year, nearly 70 percent lower than construction levels in 2000 and 2001, prior to the last downturn. In Boston this year, developers are expected to add 700,000 square feet of office space, down from 1.1 million square feet last year. Deliveries are expected to fall off considerably next year, paving the way for a demand-based recovery in 2011.
As employers continue to trim payrolls, demand for office space will wane. The national office vacancy rate is forecast to increase 310 basis points this year to 17.6 percent. Accelerating employment losses will weaken tenant demand in Boston this year, pushing up vacancy 350 basis points to 16.3 percent. In 2008, office vacancy rose 170 basis points.
Rents at the national level turned negative in the second half of last year, and further downward pressure is expected going forward. In Boston, asking rents are forecast to drop 7.6 percent while effective rents decline 9.4 percent. By the close of the year, asking and effective rents are forecast to fall 7.9 percent and 10.5 percent to $36.12 per square foot and $30.32 per square foot, respectively. Last year, asking and effective rents advanced 7.5 percent and 5.1 percent.
Fundamentals in the close-in areas of Somerville and Cambridge, both of which are dominated by biotechnology companies, will likely outperform this year, and properties in these submarkets will continue to trade at premium prices due to steady investor interest.
The year ahead will be challenging for office properties as the weak economy results in declining space demand. Job reductions in primary office-using sectors, particularly financial activities, will increase from last year. In addition, weakness in the economy is expected to spill over into secondary office-using sectors, such as educational and health services and government, which are forecast to record only minimal growth. Government employment specifically continues to be imperiled by widening state budget deficits, which may be partly alleviated by the $787 billion economic stimulus package. In fact, some of the hope for an economic recovery is pinned on the continuing intervention of the U.S. government, although it will take time for federal programs to gain traction. According to the Congressional Budget Office, 74 percent of the expenditure portion of the stimulus bill will be spent by the end of September 2010.
— Robert Horvath is a senior associate in the Boston office of Marcus & Millichap Real Estate Investment Services. Contact him at (781) 373-7100, or at rhorvath@marcusmillichap.com.