The downtown Boston office market is beginning to reflect the nicer weather of the summer season as mid-year approaches. Even without the 200,000 pre-recession jobs we are without today, the storied “Spitzer Effect” on Wall Street firms, multi-national corporations’ wide-spread consolidation and the more recent loss of a few key headquarter companies in Boston proper, Boston’s Q2 2005 results show promise for improvement in the office leasing marketplace.

Net absorption has been low and vacancy rates remain high due to the sluggish, local business climate and “jobless” recovery. However, we do find bright spots in the market.

Most recently, Boston has been holding its own and it appears to be fighting back. Our brief overview will hit the important elements in statistical results, highlights of office supply, review tenant demand and transaction velocity and offer observations on the market trends.

For a macro-view of downtown, Codman Co. tracks more than 65 million square feet, of which 9.9 million square feet remains available, with a 15.1 percent availability rate (overall vacancy rate including sublease space). Of the overall available space, sublease space totals just shy of 2 million square feet. The availability rate in Q4 2004 was 19 percent; today’s number reflects a much improved climate although still hampered by other dynamics. Even with the harsh reality of headquarter acquisitions such as ManuLife (Hancock), Bank of America (Fleet) and the pending Procter & Gamble (Gillette), the Boston statistics point towards undeniable signs and trends of improvement.

In fact, a tale of two cities actually has emerged on several fronts. The prominent occurrence is that the Back Bay is roaring back strongly when compared to the Financial District, Boston’s largest submarket. The Back Bay has carried the Boston market with a low vacancy rate of 11.9 percent and promising positive net absorption of nearly 450,000 square feet year to date. Office rents have begun to climb. In the first six months of the year, the Back Bay shows significantly more favorable results in all statistical categories. We follow Boston in each of its submarkets as noted in the Market Statistics table (top right).

We attribute numerous factors to the Back Bay’s recent success such as the introduction of a critical mass of desirable, available office space including 501 Boylston St. and ManuLife subleases at 200 Clarendon St. and 101 Huntington Ave.; the significant immigration of traditionally downtown office users like private equity firms, fund managers, legal services; organic/home-grown Back Bay tenant expansion with the likes of Liberty Mutual, First Marblehead Corp., Investors Bank & Trust and Pearson Education and one additionally very important factor – the “lifestyle effect.” It is real and it’s very significant in this 24/7 part of town.

Supply, office stock, is where we find the next tale of two cities in downtown. In reviewing several large blocks of available space one realizes the dramatic sublease space has on the market. To single out a few, ManuLife, Bank of America, State Street Corp. and Deutsche Bank alone accounts for more than 1 million square feet of sublease space. Buildings like 100 Federal St., Two International Place, 101 Huntington Ave., 33 Arch St. and Schrafft Center each can make a deal of 200,000 square feet. In fact, we found 20 spaces in our downtown market that can handle a 100,000-square-foot transaction and more than one-half of the buildings offer this space in low-rise floors. These findings do not include any future space Fidelity and/or Gillette will likely vacate in the future.

Although we make a point of highlighting these large block availabilities, it is a small portion of the overall market dynamics, for example, when taking into consideration only the premier tower properties in Boston (24 buildings), availability is less than 6 percent above the 20th floor. Below the 20th floor, the vacancy rate in the premier tower properties is closer to mid-teens. This phenomenon has assisted in bottoming-out prices in the high-rise market, and we have seen certain properties hit the $50 per square foot mark on average in small-square-footage, high-rise leases. The other tale of these two cities is how the market and some landlords are pricing their available low-rise space, often impacted by the amount of low-rise sublease space. Rent differentials can approach $20 per square feet from high-rise to low-rise opportunities due to the typical lack of demand for of low-rise space, the large size of the contiguous blocks available and the true impact of competition in sublease versus direct availability.

Relative to sublease supply, we field many questions day-to-day which lead us to believe most feel the sublease space availability sounds eerily familiar and too similar to the time when failing businesses dumped space on the market in 2002 and 2003. The truth is quite different, because the sublease space on the market today is not a result of distressed business. Simply stated, the majority of today’s sublease space is in desirable, well-located property, with good length of term remaining on the lease and typically offered by a strong credit tenant. These circumstances create significant competition to any direct available space, ultimately pressuring pricing. Look to ManuLife in the Back Bay and State Street downtown as good examples of major subleasing activity in 2005 totaling hundreds of thousands of square feet, with plenty more space to lease.

With so much sublease space in the market, opportunity abounds, which has led to a more active market with tenants investigation these opportunities. Demand tests the market and drives the bus, and without it the waters are flat. We have seen slow demand and low velocity in recent years when compared to historic 5- and 10-year models. During the 1990’s, the market averaged 1 million square feet of net absorption annually. We haven’t seen consistent positive net absorption numbers in recent years, but we are showing rays of hope in 2005 with year to date net absorption at 120,000 square feet. In today’s market, tenants have competed for certain spaces in certain properties, which indicate it is “go time” for tenants with leases expiring in the near term or reviewing expansion needs. There are 212 tenants in the market today looking for more than 5.3 million square feet downtown. There are 10 tenants in the market with needs of at least 100,000 square feet and that list carries more than 2 million square feet of the total demand. The remaining 200-plus tenants have a median requirement size of 11,000 square feet. The big ones are out there looking, but the entrepreneurial firms and privately held companies are the ones that are helping us through this recovery in Boston. The numbers are a bit of a moving target, because it isn’t as simple as identifying lease expiration dates in today’s market especially with the “blend and extends” and early lease restructurings that are prevalent at this point in a market cycle. Demand from firms such as Investors Bank & Trust, Houghton Mifflin and Goodwin, Proctor & Hoar are examples of the kind of activity that highly influences markets and takes away from future anticipated demand.

Several of the more prominent tenants creating the demand in our market at mid-year are Wilmer Cutler Pickering Hale and Dorr (350,000 square feet), Wellington Management (300,000 square feet), Bingham McCutchen (200,000 square feet), Hill Holliday (170,000 square feet), Sovereign Bank (150,000 square feet), IXIS Asset Management (100,000 square feet) and AIG (90,000 square feet). Our traditional demand feeders of banking, mutual funds, legal services and insurance are not experiencing overall expansion, yet, they still play a pivotal role in the market. Where we see much of the growth occurring is healthcare, education, software and private equity, venture capital and fund management (entrepreneurial levels).

Boston’s deal book through June has surpassed the 2.5 million square foot mark in the asset classes we follow. The Back Bay success with several significant transactions is no surprise due to the statistical results noted above. The tale of two cities continues in the review of deals done thus far with the following notable leases: Investors Bank & Trust (505,000 square feet at Copley Place and 200 Clarendon St.), Wachovia Evergreen (180,000 square feet at 200 Berkeley St.) and Pearson Education (125,000 square feet that fully completes the office leasing at 501 Boylston St.). Other deals include: Boston Medical Center (101,000 square feet at Copley Place), The United Way (48,000 square feet at 51 Sleeper St.), Babson Capital (84,000 square feet at Independence Wharf), Kirkpatrick & Lockhart (154,000 square feet at One Lincoln St.), Shepley Bulfinch (64,000 square feet at World Trade Center), University of Massachusetts (50,000 square feet at 225 Franklin St.) and DLA Piper Rudnick (50,000 square feet at 33 Arch St.).

Market trends and observations are evolving weekly in this market. It still is a tenant’s market, but the window is closing slowly. With no new deliveries to the office supply and no construction underway, and steady, moderate demand chipping away existing availability, this town will see more landlord leverage surface. Landlord concessions still abound, but with less free rent utilized to secure deals. Strong tenant improvement packages, moving allowances, etc. are also still prevalent. Several “A” buildings have appropriately lowered pricing with positive results. Good examples of this trend have been the lease-up of 100 Cambridge St., Copley Place, World Trade Center and Independence Wharf. These buildings may be just a bit off from “AAA” location by today’s standards or modestly deficient in building or area amenities, but great value has been firmly established in the recent leasing campaigns of this asset class.

Another example of trends in the market is the conversion to residential of the “B” or renovated office market. Similar to the early 1990’s when more than 1 million square feet was plucked from the downtown market for hotel, long-term stay apartments and condos, today we find more than 1.3 million square feet either sold or on the market for sale to be converted to residential property. This sales activity has an immediate impact on the class “B” or renovated market in availability and pricing, by removing office stock from the overall market. Office landlords in this asset class benefit, as well as the upper asset classes. When supply shrinks, it creates demand and an increase in deal velocity. Taking away choices for a tenant looking at a certain lower pricing point or brick & beam work environment creates needed market dynamics for owners. Some familiar properties which have fallen subject to this trend are 441 Stuart St. (142,000 square feet), 360 Newbury St. (120,000 square feet), Lincoln Plaza (200,000 square feet) and 160 North Washington St. Properties such as 40 Broad St. and 451 D St. represent 750,000 square feet of additional office stock that could be converted to residential.

On a weighted average square foot basis the average age of Boston tower space is 24 years. Boston’s stock of office space, quite simply, is old. The years 1974 and 1971 were the biggest delivery years for Boston, with 3.5 million square feet and 3.1 million square feet respectively (1988 delivered 2.9 million square feet – the modern day high). With no new tower deliveries scheduled through 2008-2009 and a shrinking office supply at the renovated asset class, it could be a race for Boston’s next tower to be developed. There are nearly 5 million square feet of proposed developments on file with the Boston Redevelopment Assoc. Good names like Hines, Beacon Capital, Equity Office Properties, Millennium, Boston Properties and Leggat McCall Properties are in line to be the next developer in the ground for office space. But before any of that occurs, much of the large existing office supply needs to be absorbed and the future space of 800 Boylston St. and One Federal St. needs to be absorbed along with whatever other unknowns lay ahead for Boston’s resilient, fighting and rebounding office market.