The poor, old office building market has taken a pretty good beating over the last three years.

Since 2000, office vacancies have risen steeply while rates have plummeted. Yet, 2004 will mark the beginning of a gradual improvement in office leasing that will benefit many owners who are positioned to react to the opportunities that will present themselves over the next several months.

Tenant activity has begun to increase as leases signed in the boom years of 1999 and 2000 roll over. Many users today utilize their space differently from when they originally signed their leases several years ago. Some need more space while most are looking to consolidate into more efficient and flexible floor layouts and shorter lease terms. The desire for efficiency and lower costs will drive tenants into the market to find the best space alternatives to meet the challenges of their new business models.

Companies that have stable long-term space needs recognize that locking in their leases at today’s low rates for longer terms makes good business sense. But many businesses, especially young companies and technology companies, are less confident of their ability to predict their long-term needs and are looking to maintain as much flexibility as possible when negotiating their next lease.

So who’s going to invest new capital in market conditions like this? Well, clearly the retail and multifamily sectors are the darlings of the investment community these days. The result is that prices for strip centers and apartment communities are getting bid up by REITS, pension funds and 1031 buyers in frenzied bidding wars. Expected returns are being squeezed razor thin as investors stretch every assumption to be as competitive as possible when bidding for properties in this environment. We are also clearly seeing premium prices being paid for well-leased commercial buildings with strong credit tenants with good term remaining in the rent roll. Last year’s sale of the Back Bay Hancock properties and the recent sale of State Street Financial Center, as well as the sale of 1414 Massachusetts Ave. and 1 Brattle Square in Cambridge have all broken records when it comes to aggregate pricing. But all of those records aren’t helping the empty buildings out there where values have been clobbered by the deteriorating market fundamentals that we are all tired of talking about.

Well actually, when you dig in and sort out the numbers, things might not really be that bad. The unprecedented negative absorption we’ve seen in the office sector for the last four years has moderated dramatically. In fact, depending on whose research you care to use, some submarkets even in the suburbs have experienced positive growth since the final quarter of 2003. And the flight to quality phenomenon is alive and well with rents firming up in the best high-rise space downtown. The expected pricing for partially tenanted and empty office buildings has fallen as expectations about a quick recovery in the office market have been moderated by the “jobless recovery.”

Much of the embedded value in empty office buildings today is in the quality and reuse potential of the existing tenant improvements. You just can’t afford to do deals today and be competitive unless you can keep the tenant improvement costs to a minimum. Also, location is as important as it has always been, although many of the best locations like Waltham and East Cambridge have experienced the greatest pain this time around.

If you can provide new tenants with good space cheap, you have a formula for success. If you can be flexible and offer “as is” deals for a two- or three-year term, you have a better chance of getting empty space filled and being in a position to benefit from increasing rents when the market improves in the next few years.

Today’s depressed prices also insure that new acquisitions of empty office buildings will be priced well-below replacement costs. One of the key issues with purchasing these buildings is that they are difficult to finance since there is no cash flow in place to service the debt and pay fixed expenses. One solution is to identify partially tenanted buildings that can provide some cash flow now and also have upside potential in the lease-up of the vacant space.

The opportunities to purchase partially tenanted buildings are limited and challenging to find, but identifying the right opportunity has the potential to be a lot more financially rewarding than competing to purchase stabilized properties where prices have been bid up to historical highs. The competition for acquiring these opportunities will be local investors teamed with private equity, patient enough to wait out the down cycle in the office market. Being flexible is key to leasing space and creating value. Utilizing existing tenant improvements keeps costs down and lets you do shorter leases, positioning the building to take advantage of the next rebound in rents.

Once the building is fully tenanted and stabilized, you can hold or sell. If you decide to sell, you’re selling in a very healthy market for stabilized properties – where low interest rates and a strong buyer pool are willing to reward you for the risks you have taken along the way. If you decide to hold onto the building, you can feel comfortable knowing you own the building well below its replacement cost and that you are probably well positioned to take advantage of a healthier market as the cycle swings back in favor of stronger market fundamentals – just as your leases are rolling over.