By Jennifer D. Duell

During the first half of this decade, there was no question that the national office market was not doing well. Rising vacancy rates, declining rental rates and weak demand forced owners to offer hefty concessions and to deal with underutilized buildings. From 2000 to 2004, the national vacancy rate doubled—increasing from roughly 8 percent to more than 16 percent while rents declined as much as 4.9 percent annually.

That's not the case today. The office market is much improved, if not completely recovered, according to analysts.

Office
# of REITs	22
Industry Market Cap. (in thousands)	$66,405,792
Yield	17.7%
YTD Total Return	3.63%
One-Year Return	13.11%
Three-Year Return	34.01%
Five-Year Return	6.65%
Average Daily Trading Volume (Shares)	128,518
Source: NAREIT. Data as of Sept. 30, 2006.

"Our sense is that the real estate recovery in general will continue to gather momentum this year and continue into next year," says Ross Smotrich, a REIT analyst with Bear Stearns & Co.

As of the end of the second quarter 2006, the national office vacancy rate had dropped and rental rates had expanded. Most owners have done away with concessions. And while the office sector recovery looked initially like a bicoastal phenomenon, coastal markets are no longer the only locales to experience increased demand: markets in the middle of the country are now gaining momentum.

Vacancy Rate Reaches Three-year Low

During the second quarter of 2006, the U.S. office market recorded 15.5 million square feet of net absorption, capping two years of declining vacancy rates.

In the first six months of 2006, The vacancy rate reached 13.8 percent, the lowest since 2003, according to Reis Inc., a commercial real estate research firm.

"Still, the office sector has not come back to nationwide vacancy levels of 10 percent, which we saw during the late 1990s, so I wouldn't say that we've completely recovered," says Sri Nagarajan, senior analyst of office and industrial REITs with RBC Capital Markets. Indeed, the U.S. economy's annualized growth rate slowed to less than 3 percent and only 108,000 new jobs were added during the second quarter of 2006, the lowest number since third quarter 2003.

Sector Strength and Recovery Rates Vary Regionally

Year-to-date, the Orlando office market has had the largest decline in vacancy rates, down 162 basis points to 8.4 percent. After Orlando, the inland markets of Cleveland, Chicago, Memphis, Phoenix, Dallas-Fort Worth and Houston boasted the largest vacancy declines, according to Friedman, Billings & Ramsey (FBR) research.

Even with this decline in vacancies, however, most of these markets still fell in the bottom third when ranked for quarter-end vacancy. "The office sector is continuing to improve, although the improvement is taking place at different rates in different markets," says Steve Sakwa, REIT analyst with Merrill Lynch & Co.

Several industry analysts continue to count New York City, Washington D.C. and San Diego as top markets. "There's still a lot of demand in these markets," points out James Feldman, an analyst with UBS Securities LLC.

Indeed, Southern Florida and Southern California as well as other coastal markets such as New York City and greater Washington D.C. are still outperforming non-coastal markets, such as Chicago, Dallas-Fort Worth and Denver.

Earlier this decade, the coastal markets suffered job losses, noted Wilkes Graham, a vice president and analyst with FBR, but "since then, the coastal markets have largely outperformed non-coastal markets, showing better rent growth and vacancy declines."

Fundamentals are almost without exception stronger on the coasts compared to land-locked markets, contends Graham, adding that people want to live and work in coastal markets, creating more demand than supply. "As a result, markets with REIT exposure are out performing the country as a whole."

In a comparison of NOI growth for coastal and non-coastal REITs, Graham found that coastal REITs achieved 5.5 percent NOI growth compared to just 1.4 percent for the non-coastal REITs. Moreover, the sum of rental growth and vacancy decline since 2003 is 10.4 percent for coastal markets but -.2 percent for non-coastal markets.

However, Nagarajan contends that the current pace of occupancy growth is actually stronger in other markets. "There's a lot more job creation in other markets than there is in New York, D.C. and Southern California," he says. "We think that occupancy growth could surprise people in Chicago and Denver."

Nagarajan cautions that occupancy improvement is not likely to translate into rental rate growth right away. "That's going to be a problem. As much as landlords try to push rents, first they have to get tenants in the door," he says.

However, most of the office REITs are performing in line with expectations, according to analysts. REITs such as SL Green Realty Corp. (NYSE: SLG), Kilroy Realty Corporation (NYSE: KRC) and Maguire Properties, Inc. (NYSE: MPG) are well positioned in coastal markets, Graham points out, but the rest of the office REITs have achieved little internal or external growth, and he doesn't expect them to in the future.

Nagarajan, however, believes that stock values of coastal office REITs may have gotten a little ahead of their fundamentals. "I think investors are overly bullish on the coastal markets, and overly bearish on other markets," he notes.

Rental Rates Briskly Grow

Beyond falling vacancies, rent gains were the high point of the second quarter with national office asking rents rising 1.6 percent and effective rents growing 2.1 percent, the fastest rate in over five years, according to Reis.

The research firm says that the gap between asking and effective rents has fallen to its lowest level since the first quarter 2003, and effective rents at the end of the second quarter were $21.41 per square foot—the highest level since the third quarter 2002.

Coastal markets led the asking rent growth: New York (3.9 percent), followed by Fort Lauderdale (3.0 percent), San Bernardino/Riverside, Calif. (3.0 percent), San Diego (2.8 percent), and Miami (2.6 percent). Moreover, many markets saw reductions in concession packages and gains in effective rents led again by New York (up 3.9 percent from the previous quarter), followed by Orange County (3.6 percent), Fort Lauderdale (3.5 percent), Denver (3.5 percent) and Los Angeles (3.2 percent).

Deutsche Bank REIT analyst Louis Taylor says that most markets posted a 4 percent rent increase, but REITs won't be able to report higher rents on lease expirations until next year. Currently, most in-place rents are way above market, and as they roll to market rates, the top line revenues for most REITs will fall in the short term.

The good news for the office sector, Nagarajan says, is that the end of the "rolling down" is almost over, and he is "mildly optimistic" about future rental rate increases.

What to Watch For

As 2006 closes and we enter 2007, office REIT investors should keep any eye out for the following issues that could impact the sector’s performance. PROS: Occupancy is improving in most U.S. office markets, particularly inland markets Continued GDP and job growth bode well for office demand Rental rate increases are more prevalent than decreases

CONS: The office sector has had a tendency to overbuild in past sector recoveries An economic downturn could substantially impact demand as companies pull back on their expansion plans Improved occupancy may not translate into rental rate growth for several quarters

Development Activity Ramps Up

Not all analysts are quite as optimistic as Nagarajan. For example, both Taylor and Sakwa note that development has increased in many markets across the nation. "In the aggregate, development is up quite a bit from two years ago," Sakwa says. "We're in nascent recovery, and people are starting to put shovels in the ground again."

In mid-2006, new construction completions totaled 14.6 million square feet, compared to 12 million square feet last year, according to Colliers International. Another 85 million square feet is under construction and expected to be completed in the next 18 months–a substantial increase from 2005 when only 58.4 million square feet was under construction.

Wachovia Securities' managing director Chris Haley contends that supply growth expectations are below demand growth expectations for the next 12 to 24 months–1 percent to 2 percent for supply and 2 percent to 3 percent for demand. However, he notes that new development in the Washington, D.C. area has picked up dramatically. This raises concerns of overbuilding, which could result in flat or decreased occupancy and negligible rental rate growth, Haley says.

However, Taylor identifies Orlando and Phoenix as markets with increasing new construction. "I'm worried that the markets won't have a chance to fully recover before construction starts up again," he says.

Sakwa agrees. "Supply is the wild card. It continues to ramp up, although it is concentrated in certain markets." He notes that at least 10 U.S. office markets, including Phoenix, San Diego and Washington D.C., will add 3 percent of new office space in the next few months. "If demand slows in the office sector, we may have a mismatch between supply and demand," he says. "The sky isn't falling, but these are warning signs.

Too much supply wrecked the market last time, and this new development could put a damper on the pace of the recovery."

Feldman concludes, "we're now at a stage where we're unsure where the economy is heading. The office sector has had a nice run, but I don't think we'll see growth and demand, especially if we head into a downturn (in the national economy), because companies will not expand."