In Boston’s central business district, tenants left behind 431,000 square feet of office space in the third quarter of 2003, resulting in a 13.7 percent vacancy rate and a $1.24 drop in Class A lease rates to $43.42.

[Editor’s note: This is the first of a two-part series examining the high vacancy rates in the Massachusetts office market. Part One focuses on the Boston leasing market, while Part Two, which will appear in next week’s issue of Banker & Tradesman, will look at the suburban markets.]

Boston commercial real estate researchers are predicting the start of yet another grim year in 2004 as more than 3 million square feet of newly constructed office space is set to come on line and large, unknown chunks of so-called shadow space – square footage that is leased but currently going unused – still threaten to flood the market. At least one more quarter must pass before the early signals of an improving economy begin to slowly translate into positive absorption of space and stabilized lease rates, experts say.

“It will be a similar dose of what we saw last year,” said Brendan L. Carroll, research analyst at the Boston office of Grubb & Ellis.

In Boston’s central business district, tenants left behind 431,000 square feet of office space in the third quarter of 2003, resulting in a 13.7 percent vacancy rate and a $1.24 drop in Class A lease rates to $43.42, according to Carroll’s third-quarter report.

But Carroll predicts that things will get worse before they get better – in the first two quarters of 2004, the 400,000-square-foot Manulife building now under construction in the Seaport district will join roster of facilities with available space, and at least another 708,000 square feet of new space planned in the Financial District also will be added. Carroll expects that the central business district’s vacancy rate will climb up to 16.7 percent.

“All of these projects are adding inventory but the need for space will remain flat,” he said.

Barbara Elia, senior vice president at the Boston office of the Trammell Crow Co., agrees with Carroll’s projections. While her numbers vary slightly, she said that her research treads in the same direction.

“The [Boston central business district] vacancy rate will go up more before it goes down and could easily rise to 17 percent,” she said. “But I think you have to take it with a grain of salt because, at the same time, there’s leasing activity. It could lead to an uptick.”

That’s exactly what happened in the 1980s and then again in the early 1990s. According to Cushman & Wakefield’s Boston Central Business District Office Market Trends report, the overall vacancy rate in 1980 dropped to 1.4 percent. That number climbed five years later and peaked in 1991 with a record 19.2 percent, only to drop once again throughout the late 1990s, when it hovered at about 5 percent. Last year, overall vacancy rates began climbing once again and in the first quarter of 2003 peaked at 15 percent. According to Cushman & Wakefield’s research, overall downtown vacancy has since dropped and remained steady in the second and third quarters at 14.3 percent.

“We’re getting to the bottom but we’re not there yet,” said Thomas L. Collins, senior managing director of Cushman & Wakefield. “We just added 33 Arch St. [to the space available on the Boston office market] … and there are still companies who have more space than they need.”

Collins also said that the market has experienced more leasing activity either from tenants forced to action by lease expirations or tenants with one or two years left on their agreements seeking good deals in a market favorable to space users.

“I’m optimistic; I think most people are,” Collins said. “The economy is showing signs of a comeback. For real estate to see a really big boost we need job growth. There’s been a little bit but we need sustainable job growth, which some people expect in the first, second and third quarters of next year.”

But Carroll said that, even with job growth, a potentially large amount of shadow space could dampen company expansions. With Greater Boston’s loss of 40,000 jobs, Carroll said that unused space across the area could total as much as 12 million square feet, based on the old rule that each employee typically requires about 300 square feet of office space in which to work.

The question that remains for industry watchers and researchers is: How soon will companies be ready to expand?

Chasing Away Shadows

While vacancy rates again increased in the third quarter, Carroll said that the explosion in sublease availability, linked to the high-tech downturn, has almost disappeared. While subleased space may offer tenants discounts of up to 75 percent, such pacts often lack flexibility for the subtenant and may impose risks that can make them undesirable, according to Carroll’s report.

Space available for sublease represents 3.1 percent of total inventory in Boston, an 8.6 percent decline from the previous quarter, according to Carroll.

There’s another bright side – while the market has sunk close to the bottom, William P. Barrack, principal of Spaulding & Slye Colliers in Boston, said that the third quarter of 2003 was the first time in two-and-a-half years that the market registered positive absorption.

“I don’t think there will be any surprises for the central business district or the suburbs next year,” he said.

In a market overview to the CCIM, Robert Richards, president of Richards Barry Joyce & Partners, compiled a list of “What’s Lukewarm and What’s Not …” Making the “Lukewarm” list in the Boston office market were lender involvement in transactions, big tenants looking to take advantage of cheaper rates and investment sales of Class B office buildings. What’s not quite so warm? According to Richards, short-term sublease space and tenant interest in Class B and C space and peripheral markets.

The interesting thing about the third-quarter numbers, Richards said, is that while direct and overall vacancy rates are up in the Financial District and Back Bay, the amount of space expected to become available in the next year decreased.

“That’s a good trend,” he said. “It appears that the worst is behind us.”

But, Richards said, current demand is driven by lease expirations, not company expansions or relocations.

“In downtown [Boston], you’re going to see some significant transactions over the next couple of quarters with users looking to lock and stabilize their real estate costs,” Richards said. “These blend-and-extend tenants are looking at consolidating [from multiple locations] and extending with their landlords.”

More lenders will also get involved as market rates slip below debt coverage and landlords need the cooperation of their lenders in securing new tenants.

For the near term, however, the Boston office market is likely to remain a bumpy ride for property owners. According to Carroll, even with flat or modest positive absorption of space, increasing vacancy rates will continue to put pressure on asking lease rates.