Landlords stepped into the new year with a renewed swagger as signposts suggested that the commercial real estate market is swinging further in their favor: Demand for Class A office space keeps increasing and vacancy rates keeps dropping, especially for the most in-demand high-rise space. Investment dollars keep flowing into the city and the cache of Boston as a world-class business center keeps growing. As a result of this confluence of factors, office rents continue to rise, with asking rates for downtown towers now more than $60 per square foot.

This backdrop is prompting the city’s largest landlords, who are trying to control more than 80 percent of the market, to flex their muscles. The stakes are even higher now for tenants to protect their interests, as local landlords, who feel they have paid their dues while tenants had the upper hand for some time, may be acting overzealous.

Reality Check

According to the fourth quarter Boston Market Review:

• Velocity in the last quarter of 2006 increased dramatically as many companies increased revenue and workforce, and expanded or upgraded their space;

• Vacancy for high-rise view space downtown has dropped to less than 5 percent and availability in all Class A submarkets, including Fort Point and the Seaport, has tightened considerably. Overall vacancy has declined slightly to 11 percent. Equity Office now boasts an occupancy rate of about 97 percent and no new construction is on the horizon;

• Massachusetts was recently ranked number one in the nation in economic competitiveness according to the Beacon Hill Institute, increasing the allure for investors;

• Domestic and foreign investors see Boston as a “favorite child,” based on its limited office supply and limited opportunities for new construction. Last quarter, Beacon Capital Partners purchased One Beacon St. for $423 million, a high point for Boston office investment sales and a benchmark for the future. To recoup the costs of purchases such as this (as well as the continued high cost for construction), landlords feel justified in spiking their rents; and

• While office rents have gradually increased over the last five quarters and now average $45 per square foot for Class A and $33 per square foot for Class B, asking rents for tower space in the Central Business District are up to $62 per square foot.

Indeed, looking ahead to the rest of 2007, these trends are expected to continue. Class A vacancy will drop even further while Class A rents may climb as much as 10 percent before the end of the year. Meanwhile, tenant concessions will likely become tighter.

But another dynamic is coming into play: It is expected that there will be a psychological barrier in the rental sweepstakes, at which point tenants will say, “Enough is enough.” That threshold will likely be around $65 per square foot. In the first quarter of 2007, Boston may be approaching that mark for the most desirable tower space, and when that happens, major employers are likely to reevaluate their options. They will find very few opportunities for large, contiguous blocks of high-quality and affordable Class A space and they will begin to explore the most desirable locations in the Route 128 market.

After a while, the 128 region, with Waltham serving as the price leader for office space, will reach its own symbolic price threshold, which is estimated to be approximately $40 per square foot – rates in Bay Colony have already passed the $30 per square foot mark. When rates hit $40 per square foot, the migration for better values will likely head further, to the Route 495 belt.

As companies gradually free up prime downtown space, setting up backroom operations in the suburbs, the market will adjust to a more moderate level, and tenants will once again gain leverage in negotiating with landlords. It is an inevitable scenario, but probably will not occur this year.

In the meantime, what should companies looking to renew or relocate do? If lease expirations are coming soon, they should plan to act in the short-term, before they incur greater risks with rising rents. If they are looking longer-term, larger space users in particular may want to test the markets west, north and south of the city. Even if companies decide not to relocate, once armed with a better understanding of the market and their options, they can strengthen their negotiations with landlords.

As always, tenants need to protect their assets and put their interests first. To do so, they should consider partnering with objective corporate real estate service advisors who represent them, not landlords. They should also seek the counsel of expert project managers who perform value engineering to determine cost-cutting measures.

Looking ahead, tenants will need to decide where to draw the line in dealing with landlords. They will need to be nimble and adjust to a changing landscape. But they shouldn’t act precipitously or defensively if overly aggressive landlords try to put them on the ropes. With good coaches in their corner, tenants should still have some fight left in them.