U.S. office sector shows signs of weakness: report

By Ilaina Jonas

NEW YORK (Reuters) - The U.S. office market showed the first indication of a slowdown in the first quarter as tenants occupied less space for the first time in more than four years, according to real estate research firm Reis.

"While rent growth remains healthy overall, the office market is showing signs of weakness amid uncertainty about the economy and short- and medium-term hiring plans," Reis' chief economist Sam Chandan said.

In the three months ended March 31, occupied office space fell by 1.73 million square feet -- the first drop since the third quarter 2003.

The national vacancy rate inched up 0.20 percentage points to 12.8 percent, marking the second consecutive quarter the rate has increased.

Tenants hesitated to sign leases for fear they won't need the space in the near future or held out for cheaper rents, Chandan said.

"There definitely are some folks out there, particularly in financial services, where their need for space may not be what they had anticipated," he said.

Asking rent rose 1.7 percent during the first quarter but has been slowing since the second quarter last year. Landlords typically do not give up on rents until well after vacancy rates rise.

Effective rent -- the amount landlords receive after concessions -- rose 1.5 percent, slowing to less than half the peak rate of 3.2 percent seen in the second quarter 2007.

Effective rent growth has fallen short of asking rent for the first time since 2004, indicating that landlords had to offer slightly larger concessions to lure tenants in the first quarter, Chandan said.

Still, year over year, asking rent nationally rose 8.8 percent. New York, by comparison, was at the top with asking rent growth at 20 percent. Effective rent grew by 9.3 percent nationally, with New York at the top at 21.6 percent.

New York remained the nation's tightest market, with a vacancy rate of 5.6 percent, unchanged from the last quarter. Washington D.C. saw its vacancy rate fall 0.2 percentage points to 7.2 percent. Los Angeles saw its vacancy rate rise 0.2 percentage points to 9.4.

Detroit had the dubious distinction of having the highest vacancy rate at 21.8 percent, up 0.8 percentage points.

The trend does not bode well for some of the priciest office real estate investment trusts that over the past four years of occupancy and rent gains emphasized development, particularly in highly dense urban areas, according to Green Street Advisors.

The buildings typically were more expensive and offered lower returns, which was not a problem in easy cheap debt days in the past, but is particularly troublesome in today's tighter credit environment. With that, Green Street this week lowered its rating on Vornado Realty Trust <VNO.N> to a "sell," and lowered Boston Properties Inc <BXP.N> and Brookfield Properties <BPO.TO> to a "hold" rating.

The downturn likely will be more muted than the prior slowdown seen after the dotcom boom went bust, and nowhere near as severe as the housing crisis, Chandan said.

The supply of new buildings has been constrained by skyrocketing building costs. Additionally, the recovery in rental rates did not start until about 2006 and seems to have peaked in 2007, which didn't give builders much time to react to stronger demand, he said.

Unlike the tech-boom years, employers did not have a voracious appetite for space and kept demand muted.

Still, investors and buyers of office buildings who paid dearly with the expectation that strong rent growth and occupancy rates would more than make up for the debt used to cover their purchase may be in trouble, Chandan said.

"The slowdown in the office market is of greatest concern for recent buyers who may be depending on gains similar to what we observed in 2006 and 2007 to meet targets for debt service coverage and to ensure refinancing requirements are met down the road in a tighter credit environment," Chandan said. "It is of concern for banks."

(Editing by Lincoln Feast)