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Empty buildings make for suite deals

It may be a tough time to get a loan to start or expand a business. But if you’re looking for office space, there are some suite deals out there.

It may be a tough time to get a loan to start or expand a business. But if you’re looking for office space, there are some suite deals out there.

The U.S. office vacancy rate in the first quarter hit 17.2 percent — the highest level in 16 years, according to a report released Monday by real estate research firm Reis Inc.

Just as the job market and overall economy seem to be stabilizing, there are early signs that the market for office space is hitting a bottom. After dropping by as much as a third, the rents seems to be leveling off, according to Reis director of research Victor Calanog.

"While we do not foresee positive rent growth resuming until next year at the earliest, office buildings at least do not seem to be experiencing as much distress relative to 12 months ago," he said in a statement.

But it's anyone's guess how long it will take for rents to recover to pre-recession levels. In the meantime, businesses looking for more space are finding bargains everywhere.

Some tenants are even negotiating free rent in exchange for signing a long-term lease. A widely watched PricewaterhouseCoopers survey of real estate investors last month reported that some 91 percent had offered prospective tenants free rent — up from 84 percent a year ago.

In hard-hit markets like Phoenix, the average seven-year lease came with 24 months free rent; in Atlanta and Chicago you could move in for up to 18 months without writing a rent check. Those incentives were lower in healthier market, but office renters in San Diego, Los Angeles and Denver were getting up to seven months free.

When that free rent is factored in, overall rents were 7.4 percent lower in the first quarter than a year earlier, according to Reis.

Nationwide, the commercial real estate market lost about 11.6 million net square feet of occupied space during the first quarter, according to the Reis report.

Owners of downtown office space told PricewaterhouseCoopers that “some companies remain skittish about the recovery and continue to return unneeded space to the market.” In suburban office buildings, “supply continues to pull ahead of demand due in large part to a ballooning amount of sublease space.

The glut of empty space has cut deeply into spending on new construction, which fell 38 percent in the last 12 months, according to the latest data from the commerce dept.

Sweet deals on office space have helped slow the increase in vacancy rates in some markets, including New York City, where William Rudin, CEO of Rudin Management, says the market is showing signs of stabilizing.

“A lot of companies are taking advantage of the pricing that is available now if you're a commercial tenant looking for space,” he said. “The sublet market has definitely stabilized, there's not an increase in sublet space. Actually there's some positive absorption in that area, and we're starting to see in certain areas, certain buildings, some price increases for the first time in probably 18 months."

Rudin said rents in Manhattan are off “anywhere from 25 to 30 or 40 percent” from the market peak in 2007.

Still, office landlords continue to face a bleak outlook, which is tied closely to the economic recovery. The wave of abandoned office space follows the steepest slide in employment in decades; office vacancy rates will likely remain high until the 8.4 million workers sidelined by the recession are put back to work.

The latest jobs data offers hope that the historic wave of job losses has crested; last month saw the first significant gain in payrolls since the recession began in December 2007. But returning to employment levels seen before the recession hit will likely take years. During the 2001 recession, it took nearly four years to restore job losses of two percent. During the latest recession, the economy shed three times as many jobs – roughly six percent of total payrolls.

Office landlords face other long-term pressures as they try to keep existing tenants and attract new one to fill empty space. Some 34 million Americans now work from home; as technology continues to allow more workers to telecommute, some companies are eager to save the overhead of providing office space.

Office building owners are also struggling with a steep decline in the value of their properties, which are also beginning to show signs of stabilizing after declining by as much as a third. That’s put many of them in the same boat as homeowners who now owe more on their mortgage than their house is worth, according to Elizabeth Warren, who chairs the Congressional Oversight Panel on the Troubled Asset Relief Program that provided a taxpayer lifeline to some of the nation’s biggest banks.

"By the end of this year, about half of all commercial real estate loans are going to be underwater,” she told CNBC last week. “And they are concentrated in the mid-size banks. We now have 2,988 banks, mostly mid-size, a few smaller ones, that have these dangerous concentrations in commercial real estate lending … So, I think we have another very serious economic problem that we're going to have to resolve over the next three years.”

And, just like underwater homeowners trying to renegotiate their mortgage, owners of commercial real estate office are trying to refinance hundreds of billions of dollars worth of loans coming due.

Many face the same dilemma as homeowners. If they sell the property, they’ll take a big loss. But to refinance, they’ll have to come up with a lot of cash to make up for the value lost since they took out the loan.

Most lenders are not especially interested in foreclosing because they’ll lose money selling into a distressed commercial real estate market. That’s prompted lenders to undertake a strategy of what industry insiders are calling “pretend and extend."

As long as the commercial property owner is making payments, bankers are willing to delay refinancing for a few years in hopes that the economy and real estate market improve. But it remains to be seen whether that strategy will work.

And some commercial property owners won’t have a patient banker to talk to when it comes time to try to postpone their refinancing. That’s because about a third of commercial loans are held by investors who bought commercial mortgage-backed securities, or bonds backed by the interest payments on those loans. After providing hundreds of billions of dollars in credit, the market for those bonds all but shut down following the real estate collapse.

There are signs of life in that market too, as investors slowly return to the market for bonds backed by commercial real estate loans. But the volume hasn’t recovered nearly enough to replace to loans coming due in the next two years.

Some property owners, like Rudin, think it’s time for the government to come to the aid to office landlords — just as it has for homeowners. One place to start, he said is to change the tax law to make the U.S. market more attractive to investors from overseas.

"Foreign investors are looking in other countries, and in the United States," he said. "Why don't we make it easier so we can get their money to come in, start investing, and help and recapitalize the marketplace?”