Ever since the technology bubble burst in 2000, global markets have suffered from economic uncertainty. “The crisis generated by the collapse of the dot-coms led to a substantial cut in corporate personnel and a resulting decline in office space that companies require,” says Isidre Serra, director of analysis for the Forcadell consulting firm.
Prospects became even worse after the attacks of September 11 and the Iraq war. Low returns on variable income equities, which are very sensitive to economic conditions, pushed investors into real estate. Demand for housing grew at a spectacular rate, inflating prices. But the market for office space did not benefit from those conditions. On the contrary, the office market depends on economic conditions. Whenever there is a recession, it means lower levels of business spending and fewer transactions in the office real estate market. “The market for office space, both for purchases and rentals, fluctuates along with economic conditions and the Gross Domestic Product (GDP),” says José Luis Suárez, who specializes in real estate and finance at the IESE business school.
The market showed the first signs of a turnaround in 2003 as a result of several factors: The economic recovery of the United States; low interest rates; and projections, generally bad, for investing in fixed and variable income instruments. Investors began to be optimistic again. Although the financial results for 2004 have yet to be consolidated, experts see clear signs of a recovery.
In Europe, London was the first market to provide positive indicators. During the first quarter of 2004, 247,000 square meters of office space were occupied, or 36% more than a year earlier. Prices in London also recovered, although more slowly. They rose 8.3% to reach £1.05 (€1.49; $1.94) per square meter. “Institutional investors, especially funds and real estate firms, were the prime movers in this market,” says a report by Knight Frank [a commercial property firm.] Rising prices were especially noticeable in London’s West End, where they moved higher without any interruption beginning in the first quarter of 2004. Rental prices in that London neighborhood are considered an indicator of the performance of other European markets. “London has registered its most significant growth in the last ten years,” says Suárez. “The London office market is very dynamic, and has very strong financial support which enables it to be more stable.”
Adds Gerardo Mochales, business and marketing director at Aguirre Newman [a Spanish real-estate consulting firm]: “London is a very mature market, where occupancy rates and prices don’t change much. In Germany and France, the market is also very concentrated. Germany has had several years of a modest economic recession. That influences demand for office space but, generally speaking, rates there have remained stable for years, unlike Spain, where they have fallen from 30% to 40%.”
According to Mochales, “In Spain, there was very strong demand for office space when the Internet boom arrived. Prices jumped [dramatically] and developers went on a construction [binge]. Some construction firms, however, jumped on board a bit later in 2001, finishing their building projects in 2003 when the market was already saturated and economic conditions for investors were unfavorable. Nothing could be done about those buildings, which pushed prices down.”
Last year, conditions turned around. Although a significant amount of office space came on the market, overall demand recovered. “The office real estate market in Spain has undergone a tremendous process of expansion and construction in recent years,” says César Oteiza, operations director at Idealista.com [Spain’s largest real-estate Web site]. “Thousands of square meters of new construction have arrived on the market, or will do so very soon. That has meant an exponential increase in the supply of space over the last four years. On the other hand, this growth has coincided with a significant contraction in demand, which sent prices down significantly. Little by little, it seems that things are getting back to normal. Quite possibly, prices will now stop dropping. Everything depends on how the economy performs. We still face some uncertainties. However, there will be some recovery in prices, and they will eventually stabilize. Companies will have a greater supply of locations to choose from, and more chances to negotiate conditions.”
The rest of Europe does not want to be left behind. Paris, the largest market in Europe in terms of office volume, also registered price increases at the end of last year. So did Milan, Stockholm and Warsaw. Overall, demand for office space in Europe grew 20% from the third quarter of 2003 to the third quarter of 2004. In the third quarter of last year, the absorption rate increased by 16% [over a year earlier.] “In 2004, a fundamental trend emerged. It is clear now that there is not an imbalance between supply and demand. Plus, prices are not very far from their historic levels,” says Pere Viñolas, director of the real estate department at ESADE, [the business school]. He adds, “For example, prices for office space in central Madrid may be low, but they are really not far from where they were 15 years ago, despite a succession of bubbles and corrections. This fact shows that this is not a bad time for office real estate.”
Tony Horrel, managing director for markets at Jones Lang LaSalle, writes that “real estate developers seem to be taking advantage of the strength of occupancy rates in Europe, and they are beginning to act. This is quite a change from last year, when they were canceling or postponing a lot of their plans for construction and investment. Moreover, in response to more liquidity in the market and higher occupation rates, investors seem prepared to invest in specific real estate products, even though they involve some risk. As a result, the vacancy rate is expected to reach a maximum level of 10% in Europe this year.”
According to Viñolas, “We may be living in a global marketplace, but you have to look at each country, one by one, to see what is happening there. You have to know what the economic conditions are in each location in order to understand developments in its real estate market.”
In Eastern Europe, the market for real estate has yet to develop significantly. The sector that has developed most is office space, where new buildings for multinationals have begun to make progress. “In 2005, there will be a greater volume of investment, especially foreign investment,” says Mochales. “However, it is still very early to talk about maturity” in these markets. Adds Suárez: “Eastern Europe is experiencing rapid development in this sector, although the most important area is residential housing. In Prague, for example, prices for office space are quite similar to those in Madrid. And in Budapest, prices are very high in the best neighborhoods.”
The American Awakening
These improvements in Europe followed the earlier recovery of U.S. markets. The first signs of improvement in the U.S. came at the end of 2003, and the trend strengthened in the middle of 2004. The U.S. market recovered before Europe did because of growing consumer spending in the U.S., and growing business optimism and confidence. These indicators helped by stimulating corporate investment in new equipment, which led to greater demand for rented office space. By the middle of 2004, the net absorption rate was on the rise, and vacant space was declining. By the end of last year, vacancy rates were almost low enough to make operations profitable for the first time since 2000. That is a significant improvement if you consider that vacancy rates were 17.6% in 2003 and 17.4% in 2002.
Moreover, the growing volume of capital coming into the real estate market meant that real estate properties were selling for higher prices.
Thanks to the U.S. economic recovery, the number of office jobs grew throughout the first half of 2004, leading to higher occupancy rates for rental properties. Office jobs rose even higher in 2004 as the country continued to grow at a projected rate of 4.7%. This stimulated demand for office space. The available supply of space dropped, pushing office rental rates up.
Suárez cautions that “the U.S. office market varies a great deal, depending on the state you’re talking about. Although the market on the East Coast has remained quite strong, the West is characterized by higher vacancy rates, and falling returns.” Suárez cites San Francisco as an example. “The market there is very sensitive to the high-tech sector, which suffered after the technology bubble burst and became depressed after the attacks of September 11.”
A similar pattern can be seen in Latin America and the Caribbean. According to estimates by the Economic Commission for Latin America and the Caribbean, the region’s average growth rate is 4%, although there are significant variations. South America has been the major engine in the region, with a growth rate of 4.4%, largely because of the relative stability of Chile’s economy and the gradual recovery of Argentina. Santiago, the capital of Chile, enjoyed six consecutive quarters of declining vacancy rates through the middle of 2004. Rental rates there have remained stable, and construction activity has registered a moderate rise. However, South America’s luster has been tarnished by high vacancy rates and declining rents for real-estate in Caracas, Venezuela. In Central America the improvement has been more modest, reaching 3.4%. In the Caribbean, the growth has been even lower, at 2.9%.
Despite such variations, forecasts for 2005 confirm a general recovery of the region. This will provide the office real estate market with increased stability, and revive construction projects that were relegated to the back burner in recent years.
What Will the Future Bring?
Experts agree that the real estate market will continue to move higher this year. For example, Jones Lang LaSalle says [in a report] that it expects higher levels of rental activity in 2005, continuing the slight improvement shown over the last two years. Nevertheless, double-digit vacancy rates are now considered something normal, and companies continue to be conscious of costs, which puts pressure on them to raise their rents. “There will be a drop in new supply in 2005, as fewer new properties enter the market. If supply drops and demand rises, they will arrive at a meeting place,” the report notes.
Although the office-space market has returned to the conditions that characterized 2001, it won’t be business as usual. An improving economy is stimulating corporate spending, but new trends in employment are having an influence on the market for office space. First of all, sources at Knight Frank note that there is less and less demand for space for establishing new offices. One reason is that companies are undergoing a period of cost-cutting. Another factor is the trend toward working at home or, more to the point, working outside the office. New, wireless technologies make work conditions even more flexible.
Beyond that, there are the changing dynamics of renting real estate in the financial centers of big cities or in business parks. The exception that confirms the rule is India, as Knight Frank notes in a report. In that country, the creation of new high-technology jobs has stimulated demand for large office buildings outside the cities. These sorts of new jobs keep growing as more and more multinational corporations engage in the practice of outsourcing. According to Knight Frank, outsourcing will reduce the net absorption rate of office space in the U.S. by 25% over the next 15 years. The same trend is taking place in Western Europe, especially in the United Kingdom.
Serra believes that a definitive recovery in the office market won’t happen unless several factors converge. These factors include “lower rates of availability, and a slowdown in new projects arriving on the market to a level appropriate for meeting demand. In addition, low interest rates will have to be maintained. As for the current year, it must be approached with caution, but with moderate optimism and confidence.” Adds Viñolas: Conditions “will depend a great deal on how the economies in each country develop.”