As 2002 begins, brokers are reporting commercial vacancy rates of more than 17 percent in the Greater Boston area.
As fireworks, champagne and confetti ushered in the New Year, few in the commercial real estate industry were sad to say farewell to 2001. Following on the heels of a record-setting year in 2000 that saw vacancies plummet to historical lows in the Boston region while rents skyrocketed, 2001 came upon the real estate industry like the unwanted hangover after an all-night party. High-tech companies that expanded rapidly in 2000 were forced to downsize in 2001, dumping unneeded space back on the market in the form of sublease space. Demand for space dropped precipitously across industries as the slowing economy forced many companies to reconsider their space options and expansion plans. As a result, leasing volume fell, vacancy rates rose, rents fell across the region, and brokers and landlords alike were left waiting for tenant demand to pick up. To make matters worse, the events of Sept. 11 created further uncertainty in a market that was already caught by surprise by the rapidity of the economic slowdown.
With 2001 thankfully behind us, the question becomes: What will 2002 hold? While everyone in the real estate industry has their opinion, the only thing that is clear about 2002 is the level of uncertainty about the prospects for commercial real estate and for the economy in general during the coming year. What impact will world events have on the economy and real estate in particular? Will the economy experience a recovery in 2002? Will tenant demand pick up? While some industry observers have speculated that there may be a strong recovery in the real estate market during 2002, it seems likely now that 2002 will probably be another slow year for the commercial real estate market in Boston. While the market will be stronger this coming year than it was in 2001, with greater leasing activity and tenant demand, the market will require time to flush out the sublease space and absorb the vacancy that the market is now experiencing. But at the same time, real estate will continue to generate steady cash flow and some of the best risk-adjusted rates of return for those investors that have bought right and have aggressively managed their assets over the last few years.
Negative Trend
By the end of 2001, local brokers were reporting that leasing activity seemed to be picking up, as tenants slowly began to move from the sidelines back into the marketplace. While this is definitely a good sign, these tenants certainly have a lot of options to consider. Today, brokers are reporting vacancy rates, including sublease space, of more than 17 percent for Greater Boston, with vacancy rates in Cambridge and many suburban submarkets hovering at or above 20 percent. Negative absorption in 2001 essentially wiped out the strong absorption gains of 2000, and rents have fallen back to 1998 levels in many submarkets.
With the economy expected to pick up somewhat in the coming year, we will probably see a moderate increase in leasing activity, as tenants look to take advantage of the attractive leasing opportunities available in the market. At the same time, tenants who delayed making leasing decisions in 2001 may be forced to commit to space in 2002. The market, however, is likely to see many tenants who simply move to new locations without taking additional space, or who may actually downsize and take less space.
While 2002 will not see the influx of sublease space that 2001 witnessed, attractive sublease opportunities will continue to attract tenants away from direct leases and may continue to place downward pressure on rents. In addition, much of the sublease space currently on the market is not very attractive to potential tenants due to short lease terms or the suspect credit of the sub-landlord and, as a result, this space will continue to sit like a dead weight on the market.
In a slow market, 2002 should see very little new speculative development. However, new construction that came to market in 2001 along with 2002’s construction completions will certainly place more pressure on the market, just as existing buildings are struggling to lease up vacancies.
From a national perspective, Boston remains one of the most attractive cities for real estate investment due to the strong long-term economic fundamentals of the market. As a recent survey by the Association of Foreign Investors in Real Estate pointed out, Boston continues to be among the top five cities in the nation for foreign real estate investment. Nonetheless, the second half of 2001 saw a significant drop-off in transaction volume, as uncertainty in the markets made underwriting deals more challenging. In addition, many sellers have been unwilling to drop their pricing and have opted to refinance and hold on to their assets, which has significantly decreased deal flow. For at least the first half of 2002, this slow investment momentum will probably continue. However, if leasing activity picks up and the market stabilizes, buyers and sellers may be more willing to complete transactions. While undercapitalized investors may be forced to sell in 2002, everyone in the real estate business continues to wonder whether pension funds and opportunity funds will elect to sell off assets due to timing issues or asset allocation constraints within their portfolios, a trend that would create attractive opportunities for well-capitalized buyers.
In the end, 2002 is likely to be a flat year for the commercial real estate market. However, companies that bought right in the last several years and that have aggressively managed their properties will continue to weather the uncertainty with strength, while continuing to generate strong cash flow to their investors. And for investors and real estate managers who are well positioned and capitalized, adversity in 2002 will yield significant investment opportunities.
