New office supply at 33 Arch St. and other locations around Boston has boosted local availability to some 10 million square feet.

The U.S. appears to have weathered the economic storm of recent years and has shown signs of a broad macro recovery.

According to independent economists and Wall Street firms, there are prevalent expectations for a continued but slower recovery in 2005 with a GDP growth rate of 3 percent to 4 percent – down from 5 percent growth in 2004. This means that the mergers, acquisitions and consolidations that we have witnessed over the pasts few years domestically have only modestly aided and spurred national economic improvement.

Today, job creation must reach nearly 150,000 jobs per month to spark a true recovery in the commercial real estate sector, which typically lags a broader economic recovery by as much as 12 months. Boston is in for an uphill battle in 2005, thanks to recent local market activity such as ManuLife’s acquisition of Hancock Financial Services and Bank of America’s acquisition of Fleet Bank, and because of the continued consolidation of large corporate office-space users such as State Street and MFS Investment Management, among others. Troubling trends and tough landlord conditions seem like they will prevail in most downtown Boston asset classes.

Market Snapshot

Downtown Boston has an office market of approximately 57 million square feet. Velocity was good during 2004, with more than 750,000 square feet of leases signed through the middle of the fourth quarter. But local mergers and consolidations (1.9 million square feet of sublease space) brought the dwindling sublease market availability back to a whopping 4 million square feet. Back in 2002, nearly 50 percent of available office space in Boston was sublease space. Today it is only 25 percent of the availability downtown. Overall availability measures nearly 18 percent over all asset classes.

One bright spot is above the 20th floor in tower assets where vacancy is below 5 percent and activity is strong. Rental rates are expected to stabilize in the upper floors over the next 12 months.

There are concerns in the mid-rise and low-rise portion of the tower market and in the lower asset classes where higher vacancy looms and pressure on rental rates and concessions continues. Demand today approaches 4 million square feet but limited options exist for large tenants (nine options at 100,000 square feet; four options at 200,000 square feet).

More than 70 percent of activity in the market comes from tenants of 10,000 square feet or smaller. There is tremendous competition for the best spaces, but there are scores of options for this prospect group. Among larger requirements in the market are Investors Bank and Trust (450,000 square feet), Fidelity Investments (375,000 square feet), Houghton Mifflin (300,000 square feet), Testa Hurwitz (250,000 square feet) and Kirkpatrick & Lockhart (100,000 square feet).

Rental rates range from $40 to $47 per square foot in tower properties and $23 to $30 per square foot in the renovated asset class. The outlook for rental growth is more than 24 months away largely due to the lack of net absorption and slow demand in a market with more than 10 million square feet of available supply (that’s seven year’s worth of demand and it would be nearly four years before reaching single-digit vacancy, barring any unforeseen financial market crash or terror event).

New supply was added in 2004 from major assets such as 33 Arch St., 501 Boylston St., and 100 Cambridge St. Each is well into successful leasing campaigns with lead tenancies signed: the new major leases are Digitas (200,000 square feet), Pearson Publishing (106,000 square feet), and American Student Assistance (100,000 square feet) respectively.

Also, ManuLife’s new headquarters at 601 Congress St. was brought on line late in 2004. Other significant 2004 leasing transactions include First Marblehead Corp. (284,500 square feet), Choate Hall (155,000 square feet, Wachovia (171,000 square feet), Ernst & Young (139,000 square feet) and Boston Medical Center (100,000 square feet).

Market Trends

There are a number of trends that began to unfold in 2004 and that are likely to continue tin 2005.

• Big block, long-term subleases. Several of the largest blocks of sublease space are true competition for direct availability due to the quality, quantity, and location of the space coupled with length of remaining term.

• Flight to extreme value. Searching for the most cost-effective space in the highest quality property, often with significant asset class upgrades.

• Blend and extend. Early lease renewal and restructuring business terms is prevalent as tenants take advantage of market conditions favorable for them. Future leasing demand, in these instances, is protected by existing landlords (stolen from the open market).

• Bifurcated market. Product market is segmented by location within district and location within the asset; quality locations and upper floors of high-rise space are most popular.

• Consolidation/downsizing. Corpor-ations continue to find ways to use space more efficiently, downsize operations where possible and consolidate multiple locations where appropriate.

• Conversion. Lower asset class properties in the office market sector convert to residential in response to flight from the asset class. Well located, high vacancy and pressure on lower rents drive owners to find alternative uses for income generation.

• Highly measured and conservative acquisition of space. Prospects are carefully investigating all possibilities prior to committing to new space. Due diligence has never been so heavy in the leasing market.

Market Forecast

White-collar job growth alone cannot be the savior of the Boston office market, but it sure is one of the key indicators. However, this indicator does not show favorable signs domestically for several reasons and shows signals of a slow, extended recovery.

With overall economic trends including increase in employee productivity, improvement in information technology and associated administrative technological advances, as well as globalization of the workforce, the overall domestic employment numbers are fighting to maintain an even keel.

Locally and nationally, we have seen the negative impact on the office workforce in many ways over the past 24 months. For example, jobs in call centers, IT coding, consulting and support, accounting services and R&D are all somewhat vulnerable for continued exportation to Asia and Europe as corporations push to downsize, lower operating costs and post better earnings. The local economy has, and will, suffer from the hangovers of the MetLife, ManuLife and Bank of America mergers; and the financial services and insurance issues of Putnam, MFS and Marsh Mac.

These firms and others are traditionally big space users. But all are using much less office space today. We expect to see velocity between 700,000 square feet and 1 million square feet, but net absorption downtown will prove to be flat in 2005 (10-year historical average for net absorption was 1.1 million square feet prior to 2001).

We anticipate shadow space diminishing as leases are restructured or expire; at one point in late 2003/early 2004 as much as 10 percent of major office user’s space was estimated as excess, but not for sublease.

The traditional demand feeders for Boston had been financial services, banking, legal services, advertising and insurance. These industries still occupy large amounts of office space within the city, but each has fallen victim to the global trends.

Vacancy rates will not be affected significantly. Overall vacancy will settle in the 16 percent range and we will see some big deals made in the sublease market out of the gates in Q1 2005.

Rents will hold firm in the high-rise portion of the market, but will show signs of weakness in the low-rise and renovated asset classes as stabilization in these areas is still off in the distance. Landlord concessions will be given for specifically targeted deals, but increases across the board in concession packages will not be prevalent. The bottom is here or near in the concession category.

In 2005, most tenants will continue to have numerous and multiple leasing options. The only exceptions will be deals of true significance, 100,000 square feet and larger, where the options can be counted on your fingers. New office supply is not anticipated, but several million square feet remain in the pipeline and approved by local authorities. Look for at least one or two blockbuster leases to be consummated in Boston in the year to come.