April 05, 2011, 12:08 AM EDT
By Hui-yong Yu

April 5 (Bloomberg) — Office vacancies in the U.S. dropped for the first time in more than three years in the most recent quarter and rents climbed, signaling the market is beginning a recovery as the economy improves.

The national vacancy rate fell to 17.5 percent in the first quarter from 17.6 percent in the previous three months, Reis Inc. said in a report today. The drop was the first since July through September of 2007. Asking and effective rents rose for the second straight quarter after more than two years of declines, the New York-based property-research firm said.

“This is the first quarter, at least on a national basis, where the change is strong enough to qualify it as the first quarter of a recovery,” Ryan Severino, an economist at Reis, said in an interview. “We have finally gotten to an inflection point where the good is starting to outweigh the bad.”

The rebound in demand for office space is spreading beyond New York and Washington, which have been leading the growth, Reis said. Gross domestic product growth adjusted for inflation has been positive for the past six quarters as the U.S. economy emerged from the recession. Employers have added jobs for six consecutive months, according to the Bureau of Labor Statistics.

Preliminary figures from CBRE Econometric Advisors are similar to Reis’s findings. The office vacancy rate fell to 16.5 percent in the first quarter from 16.8 percent a year earlier, the first year-over-year drop since 2007’s third quarter, according to the Boston-based firm. Vacancies were unchanged from a revised fourth-quarter level, said Arthur Jones, senior economist at CBRE, a unit of CB Richard Ellis Group Inc.

‘Lot of Risks’

“There are signs the market’s entering a recovery but there are a lot of risks,” Jones said in a telephone interview. “We need to see another quarter’s worth of data before we’d say the market’s swung into recovery.”

San Francisco, Pittsburgh, Dallas and Austin, Texas, are among the cities most likely to have rent gains next year, Jones said. Boston and Salt Lake City also may see increases, he said.

“The office market as it sets up for recovery is kind of a wave from the East sweeping to the West,” he said. “We are forecasting still-modest rent increases for the national market in 2011, but 2012 is really when the job market will be healthy enough where we’ll see demand tick up even more.”

Washington had the lowest office vacancy rate in the first quarter at 9.2 percent, followed by New York at 10.7 percent, according to Reis. Detroit and Phoenix had the highest vacancies at 26.6 percent. Nationally, vacancies rose from 17.3 percent a year earlier.

Occupancy Gains

Office buildings gained a net 4.7 million square feet (436,640 square meters) of occupied space in the first three months of the year, the second consecutive increase following 11 straight quarters of declines, Reis said.

Landlords’ asking rents increased to an average $27.66 per foot in the first quarter from $27.53 in the previous three months and $27.57 a year earlier, the research firm said. Effective rents, or what tenants actually pay, climbed to $22.20 per square foot from $22.09 in the fourth quarter. They were down from $22.25 in the first three months of 2010.

The increase in asking rents “demonstrates that landlords feel confident enough about their prospects to move beyond simply adjusting concessions,” Severino said.

Effective rents rose or stayed the same in 45 out of 79 markets last quarter. That was up from 39 in the previous three months, another sign that landlords are more optimistic, according to Severino.

New York, Pittsburgh

New York and Pittsburgh had the highest effective rent increases from a year earlier, at 2.8 percent, followed by San Francisco at 2.7 percent, Reis said.

Pittsburgh “has held up really well,” said Jones of CBRE. The city’s concentration of employment in the energy industry has helped bolster rents, he said.

“They’ve managed to skirt the recession,” Jones said. “The market’s tight enough to support further rent growth. It’s a small market but one that’s performed really well.”

Further gains may come from San Francisco and Austin, helped by strong demographics and technology-industry jobs, according to Jones.

“There are real constraints on supply in San Francisco,” he said. “It’s really hard to develop, particularly in downtown areas. That’s a market where you could see some sort of rent spike in the next couple of years as employment accelerates.”

Dallas is “on the cusp of recovery,” helped by the presence of energy companies, relatively low operating costs for businesses and a growing population, Jones said.

Employment Recovery

The office market generally improves about 12 to 18 months after employment begins to recover, Severino said. It has now been one year since the job market saw its first gain in March 2010 after shrinking for the previous 25 months, he said.

A further recovery “all depends on the rate of corporate hiring,” said Chris Macke, senior real estate strategist at CoStar Group Inc., a Washington-based provider of property market research. His firm estimates the U.S. office vacancy rate fell to 13.4 percent in the first quarter from 13.5 percent a year earlier, and was unchanged from the end of 2010.

“The office recovery has been slow,” Macke said. “The good news is that rather than hemorrhaging and continuing to see significant increases in vacancy, the rate is actually now going down.”

–Editors: Kara Wetzel, Josh Friedman

To contact the reporter on this story: Hui-yong Yu in Seattle at hyu@bloomberg.net

To contact the editor responsible for this story: Kara Wetzel at kwetzel@bloomberg.net