MARKET HIGHLIGHT, JULY 2009

BOSTON MARKET HIGHLIGHTS

Boston Office Market

Job cuts among financial and professional services firms will cause office fundamentals to weaken in Boston this year, but modest amounts of new construction will temper the supply and demand imbalance. With layoffs at State Street Bank, Bank of America, Merrill Lynch and Fidelity Investments projected to total in the thousands, a resulting decline in office space demand will drive up vacancy for the second consecutive year. In the CBD, negative net absorption of approximately 550,000 square feet will raise the average vacancy rate nearly 200 basis points to the high-11 percent range.

While tenant demand across the metro will wane in the near term, tighter construction financing and lingering economic concerns have reined in development activity. Completions in 2009 will drop off from last year and will represent only a 0.6 percent expansion of metrowide inventory, helping to offset reduced employment-generated demand.

Weakening fundamentals and an uncertain economic outlook will underpin conservative buyer expectations this year. As a result, deals will be underwritten assuming higher vacancy rates and rent declines, elevating cap rates metrowide.

Currently, initial yields are averaging in the high-6 percent to mid-7 percent range, up about 25 basis points to 50 basis points over the past year. Investment opportunities exist in the Back Bay/Fenway submarket, where Class B/C vacancy is around 10 percent and vacancy in top-tier assets is 6 percent. Buyers willing to reposition lower-tier buildings in the area could capture upside potential through higher rents when the market stabilizes.

Sales activity has been slowed by uncertainty surrounding price discovery, particularly in the $20 million-plus price segment. As more distressed assets enter the market, floor-level pricing will become apparent, making it easier to establish values for stabilized properties. The decline in the stock market has altered allocations of real estate in many investment portfolios, which could create some buying opportunities if pension funds and institutions sell real estate assets to improve liquidity.

Unlike past cycles, overbuilding is not the major cause of the current downturn. Nationally, office deliveries are forecast to total 51 million square feet in 2009, following the completion of 58 million square feet last year, nearly 70 percent lower than construction levels in 2000 and 2001, prior to the last downturn. In Boston this year, developers are expected to add 700,000 square feet of office space, down from 1.1 million square feet last year. Deliveries are expected to fall off considerably next year, paving the way for a demand-based recovery in 2011.

As employers continue to trim payrolls, demand for office space will wane. The national office vacancy rate is forecast to increase 310 basis points this year to 17.6 percent. Accelerating employment losses will weaken tenant demand in Boston this year, pushing up vacancy 350 basis points to 16.3 percent. In 2008, office vacancy rose 170 basis points.

Rents at the national level turned negative in the second half of last year, and further downward pressure is expected going forward. In Boston, asking rents are forecast to drop 7.6 percent while effective rents decline 9.4 percent. By the close of the year, asking and effective rents are forecast to fall 7.9 percent and 10.5 percent to $36.12 per square foot and $30.32 per square foot, respectively. Last year, asking and effective rents advanced 7.5 percent and 5.1 percent.

Fundamentals in the close-in areas of Somerville and Cambridge, both of which are dominated by biotechnology companies, will likely outperform this year, and properties in these submarkets will continue to trade at premium prices due to steady investor interest.

The year ahead will be challenging for office properties as the weak economy results in declining space demand. Job reductions in primary office-using sectors, particularly financial activities, will increase from last year. In addition, weakness in the economy is expected to spill over into secondary office-using sectors, such as educational and health services and government, which are forecast to record only minimal growth.

Government employment specifically continues to be imperiled by widening state budget deficits, which may be partly alleviated by the $787 billion economic stimulus package. In fact, some of the hope for an economic recovery is pinned on the continuing intervention of the U.S. government, although it will take time for federal programs to gain traction.

According to the Congressional Budget Office, 74 percent of the expenditure portion of the stimulus bill will be spent by the end of September 2010.

— Robert Horvath is a senior associate in the Boston office of Marcus & Millichap Real Estate Investment Services.

Boston Industrial Market

In my estimation, our market has not suffered in the last 6 to 12 months as much as many other markets in the U.S., including areas such as Miami and Detroit. We are, however, definitely in a “recessionary climate” with negative absorption in both the office and industrial markets in the first quarter 2009. The vacancy rates in office, flex and warehouse space have also increased modestly in the last quarter. The capital markets sector has, predictably, been affected more severely by the current recession. The combination of declining LTV ratios, overly cautious banks, CMBS debt maturing, and skyrocketing CAP rates have caused the investment market to erode significantly.

While all sectors of the market have been affected by the recession, lab and pharmaceutical related companies have performed more admirably in general in the first quarter of 2009. Vertex Pharmaceuticals, for example, recently leased 100,000 square feet.

The most significant industrial leases signed this year were a 144,600-square-foot lease signed by Fenwal Controls at 400 Main Street in the Route 495/Mass Pike West market; the aforementioned Vertex Pharmaceuticals lease in the Cambridge market; and a 79,000-square-foot lease signed by Expeditors International of Washington, Inc at Three Technology Drive in the Route 128 North market.

Tenants moving into large blocks of space this year include Polar Beverages, which will occupy 182,000 square feet at 150 Blackstone River Rd; Ameridose, which will move into 76,128 square feet at 205 Flanders Rd; and Curtis-Strauss LLC, which will occupy 60,000 square feet at Littleton Distribution Center.

The Boston industrial market ended the first quarter 2009 with a vacancy rate of 11.8 pecent. The vacancy rate was up over the previous quarter, with net absorption totaling negative (1,295,080) square feet in the first quarter. Vacant sublease space decreased in the quarter, ending the quarter at just over 2.6 million square feet.

Rental rates ended the first quarter at $6.94. The average quoted asking rental rate for available industrial space was $6.94 per square foot per year at the end of the first quarter 2009 in the Boston market area. This represented a 1.7 percent decrease in quoted rental rates from the end of the fourth quarter 2008, when rents were reported at $7.06 per square foot.

The amount of vacant sublease space in the Boston market decreased to more than 2.6 million square feet by the end of the first quarter 2009, from more than 3 million square feet at the end of the fourth quarter of 2008.

Although, the Boston market has not suffered as much as others, development has slowed as people take on a wait and see attitude. During the first quarter 2009, seven buildings totaling 186,436 square feet were completed in the Boston market area. This compares to nine buildings totaling 158,361 square feet that were completed in the fourth quarter 2008; 10 buildings totaling 666,383 square feet completed in the third quarter 2008; and 170,020 square feet in five buildings completed in the second quarter 2008.

There was, however, 858,000 square feet of industrial space under construction at the end of the first quarter 2009. Two notable deliveries in the first quarter included: 180 International Drive, a 54,000-square-foot facility which is now 100 percent occupied; and Tee’s Plus at 589 Commerce Drive, a 40,000-square-foot building.

The largest projects underway at the end of first quarter were 400 Patriot Way, a 200,000-square-foot building with 100 percent of its space pre-leased; and 417 South St, a 145,000- square-foot facility.

The suburban Boston office and flex markets in the last two decades have been characterized by fast-moving, highly innovative start-ups that have, in many instances, grown to become dynamic entities. The phenomenal amount of talent graduating from many of the nation’s most prestigious universities and technical colleges in the greater Boston area almost guarantees that Boston will remain a dominant player in the world of technology including pharmaceutical and robotics. People should continue to watch all high technology fields as potentially strong “growth areas.”

— David G. Stubblebine is president of The Stubblebine Company/CORFAC International.

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