From the September 2009 issue of Research Magazine • Subscribe!

Hard Times in Office Space

Conversation over lunch at Nocello with William E. Hartman, Executive Vice President, Cushman & Wakefield

Who: William E. Hartman, Executive Vice President, Cushman & Wakefield

Where: Nocello, 257 West 55th Street, New York City, July 27, 2009

On the Menu: Gnocchi, salmon and real estate travails

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Nocello, a midtown Italian restaurant I reserved for a lunch interview with Cushman & Wakefield's William Hartman, happens to face a long blue construction fence stretching the entire length of a city block. Behind the fence, the foundation of another huge Manhattan skyscraper looks nearly complete.

"These people must feel sorry the building across the street wasn't built," observes Hartman, surveying the sparse lunch hour crowd at the restaurant. Alas, 250 West 55th Street, a glittering 39-story, 1 million square foot all-glass office tower designed by world-renowned architects Skidmore, Owings & Merrill and developed by Boston Properties, has been a hole in the ground since February.

In fact, observes Hartman, the expected anchor tenant in the building, law firm Proskauer Rose, re-signed its lease in nearby Worldwide Plaza, a 1.8 million square foot complex owned by Deutsche Bank after developer Harry Macklowe defaulted on $7 billion in loans. Deutsche recently sold the building for $600 million, or around $330 per square foot. To gauge how far New York real estate has fallen it would suffice to say that Macklowe bought Worldwide Plaza for $1.7 billion in early 2007 and as recently as December 2008 Deutsche was negotiating a deal to sell it for $2 billion.

This is symptomatic of the real estate situation in New York, says Hartman. There is a glut of vacant office properties and rents have fallen by an average of 44 percent. If special deals, free rent and other perks are taken into account, a decline in rents turns out to be even more dramatic. You can now buy a building for a fraction of what it costs to build a new one -- which is why so little goes on behind numerous blue construction fences around New York City.

Top to Bottom

"This crisis has been very different from previous ones," says Hartman. In the past, a real estate crisis was felt initially in less desirable segments of the market, where rents and prices fell and vacancies rose. Then, in more severe downturns, the market for top-notch properties would begin to soften, as well, although typically not by much.

But now, it has been exactly the opposite.

"The top of the market was hit first, because so many leading financial firms failed or had to cut their staffs," he says. "On the other hand, all those B-class properties began to feel the pain later, after it was already felt on Park Avenue."

Similarly, Manhattan -- where Hartman specializes in office space rentals and investment deals -- was hit first and hardest. Now, the blight is impacting other markets, even though in other cities, where prices didn't rise quite as much as they did in Manhattan, there has been less room to go down.

A curious aspect of the current recession is the chain reaction dragging down real estate and financial services industries in tandem. The crisis began in residential real estate, but the crux of the matter was severe overleveraging, which triggered mortgage delinquencies and a financial crisis. After the collapse of several top-flight financial institutions, the crisis spread into commercial real estate, where developers and building owners are also severely leveraged. The deleveraging process is still going on. Banks remain reluctant to lend and demand a far larger equity participation in every deal.

One factor supporting office space in Manhattan, says Hartman, may be the fact that during the past several years, even before the advent of the crisis, the construction of office towers slowed, and most construction activity focused on apartment buildings instead. Some older office buildings, especially downtown, were even remodeled and turned into condos. Now, while there isn't much new office space coming on line, at least not speculative construction, new condos are being finished without many buyers in sight, making lenders extremely nervous.

A similar story is unfolding in the hotel segment -- only worse. "Office buildings at least have tenants with long-term leases," notes Hartman. "Hotels can lose occupancy overnight." Despite offering tremendous discounts to shore up their occupancy rates, a number of hotels in Manhattan are being forced to file for bankruptcy.

History Lesson

Real estate is a notoriously volatile sector and Manhattan real estate is especially prone to dramatic ups and downs. Hartman recalls that he started in this business exactly 20 years ago, in 1989 -- which was another severe downturn in Manhattan office space.

"In many ways, it was worse back then," he says. "It's true, rents and prices hadn't risen quite as high, but overbuilding was more severe in relative terms. And there wasn't as much money sitting on the sidelines and waiting to get in."

The question for all that money waiting in the wings is when it is safe to get in. The fact that prices for real estate are below replacement costs is an encouraging sign. But vacancy rates are high -- and rising. A Cushman & Wakefield review of Manhattan commercial real estate noted that the vacancy rate in offices rose to 10.5 percent in the first half.

"We may see vacancy rates rise to 14-15 percent," cautions Hartman.

At the same time, land prices have come down sharply as well, starting to reduce office space replacement costs. Banks are extremely apprehensive about providing new loans.

Still, compared to the first quarter of this year, when it looked like the entire financial system could go bust, conditions have brightened considerably. Investors no longer worry that the sky is about to fall, and increasingly see the situation as a downside of a cycle -- albeit a more severe one than usual. This means that like in 1989, when some owners literally walked away from their properties, those who have the foresight and the guts to buy at the bottom will make a lot of money.

"There is going to be a major transfer of wealth in this cycle," predicts Hartman.

Some buyers are ready to take a plunge if the price is right, as evidenced by the Worldwide Plaza deal. Hartman was recently involved in another landmark signing. Pharmaceutical giant Eli Lilly took a 15-year lease on 100,000 square feet at East River Science Park, becoming an anchor tenant in the development. This will be an oncology research center for its unit ImClone Systems.

Some parts of commercial real estate are doing relatively well, including research labs and medical and educational facilities. Hartman notes that over the past decade such tenants were often priced out of the prime real estate market in Manhattan, even though this is where educated, highly skilled workforce is concentrated. Now, new kinds of tenants may be moving into vacant offices.

Diversity and mobility is the strength of the New York City economy. It has been able to replace manufacturing jobs with financial services jobs and now it may be the turn of something else. Resilience has also been characteristic of the U.S. economy as a whole. It is true that the unemployment rate is extremely high and some of the old jobs will not be coming back. But other sources of employment growth -- and office building tenants -- are likely to be found in the end.

This is a hopeful view. However, getting back to my office after lunch I find a flyer stuck under my door. In case I wish to move, an enterprising real estate management company is advertising two dozen nearby office buildings renting entire or partial floors for $30-35 per square foot. Hartman has just told me that at the peak of the cycle prime office space went for $90-plus per square foot. The market obviously has not reached bottom yet.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past six years, 2004-2009.

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