Manhattan Office Space Increases Post-Sept. 11

The effects of the September terror continue to linger for New York City landlords. Top that off with an economic downturn, and the Lower Manhattan real estate market is feeling the pinch.

Perhaps most surprising is that many firms displaced by the World Trade Center attacks -- while scrambling to find new space -- are making do with significantly less square footage than before.

The six buildings that made up the World Trade Center complex contained nearly 13.4 million square feet of office space that was 97% leased. However, data from real estate consultants Grubb & Ellis suggest that displaced tenants have signed leases for about 39% of the space leased prior to Sept. 11. In fact, though the terrorist attacks destroyed or damaged nearly 35% of Downtown Manhattan office space, the drop in demand has been even greater.

Merrill Lynch's Leonard Sahling had similar findings in a recent report on the Manhattan office market. "It appears that the tenants displaced from the World Trade Center will end up leasing significantly less replacement space in New York City than they had formerly occupied," Sahling writes.

Retrenchment

The consensus that in the aftermath of Sept. 11 Manhattan office space would be tough to find has proved incorrect. And feared price gouging and hoarding never materialized.

In fact, vacancy rates rose. Manhattan vacancy rates increased to 9.1% last month, from 8% in September. And the impact has been even greater in the downtown area, especially around Wall Street, with Lower Manhattan office vacancies now running at 10.7%, compared with 7.5% in September. And rent rates have declined precipitously in Lower Manhattan, down 10% since September. In midtown, meanwhile, rents have remained relatively stable.

"We had expected to see New York City's overall vacancy rate decline from 8%, where it stood on Sept. 11, to 5% or less, depending on how many displaced tenants decided to remain in the city as opposed to moving to the suburbs," notes Sahling.

That proved incorrect as analysts underestimated the amount of "extra" space corporations were hoarding for future growth -- space that quickly flooded the markets after Sept. 11. A slowing economy, corporate downsizing and layoffs -- especially on Wall Street -- eliminated the need for companies to hold that extra space.

Nobody could have predicted how much "extra" space was being held by Manhattan businesses, especially financial services companies that had expected to need it for future growth.

"People overestimated the impact of losing space downtown," says Sam Lieber, CEO of Alpine Management & Research and portfolio manager of the Alpine U.S. Real Estate Equity Fund. "What they didn't realize was how flexible some of the neighboring areas could be and how much stealth sublet space was out there." Lieber refers to space brokers did not know was available, but which quickly opened up as firms reassessed and downsized their occupancy growth plans.

In fact, according to Sahling, nearly 4.5 million square feet of new space has made it to market since Sept. 11. And nearly 10 million square feet of sublet space has come to market as a result of corporations reassessing their space needs.

All that space, combined with slackening demand, has put real pressure on rent rates. "There are buildings that were leasing for $70 per square foot at the peak of the market that are now subletting on high floors for $40 per square foot," says Lieber. "I think we will continue to see some very quick rent adjustments. The question is how much more sublet space comes on the market and how soft prices get."

Tale of Two Markets

While all of Manhattan has felt the impact of the terror and slumping economy, Downtown markets have really felt the pain.

"Considering the substantial runup in available space in Lower Manhattan during the past two months, it's likely the vacancy rate in the downtown market will climb sharply in the coming months and peak in the vicinity of 17%-18% late next year," notes Sahling.

That's in sharp contrast to the 8% peak predicted in Midtown late next year.

"Midtown will remain one of the healthier markets in the country," says Lieber. "At the same time, downtown is a mess."

While an economic rebound may reverse the downsizing of Wall Street firms, other issues will linger. "Quality-of-life issues appear to be the impetus from Lower Manhattan," notes Sahling. "Companies are seeking to escape from the still smoldering ruins of the World Trade Center, the awful air pollution, the disabled transportation system and the aging inventory of the office product. It'll be years until those vexing problems are fixed."

Estimates from Merrill and others suggest that downtown rent rates could fall to as low as $30 per square foot in the coming year -- at least $25 per foot less than comparable space in Midtown. That would be the largest-ever disparity between the two markets.

"Downtown will remain a tough market for a while," says Lieber. "With everything else, the Wall Street firms add an element of boom and bust to the cycle, and that is only making the situation worse."

REIT Ideas

While the sagging economy will affect rent rates, the length of the downturn will determine the impact on landlords. "The big question mark for New York is how long the economic downturn lasts," says Lieber. "If the economy picks up in the second half of the year, the impact on office REITs won't be that bad."

In New York, he likes Vornado (VNO Quote - Cramer on VNO - Stock Picks). "Vornado has smart management and plenty of available capital," Lieber says. "And they don't have large lease rollovers in the coming year. If the economy remains soft for more than a year, then you become more cautious."

He is less sanguine about SL Green (SLG Quote - Cramer on SLG - Stock Picks), noting the company has a good lease portfolio but that its expectations are a bit grand. "It's also a company that just began to cover its dividend with cash flow, so I would be a bit more cautious," he says.

In the suburban markets, he thinks the valuations on Reckson (RA Quote - Cramer on RA - Stock Picks) and Mack Cali (CLI Quote - Cramer on CLI - Stock Picks) are reasonable, though he is more cautious about the impact an economic slowdown will have on suburban real estate.

"The way this cycle has moved so quickly with vacancies dropping, the pendulum has swung in favor of the tenant," Lieber says. "If we see an extended downturn, that could leave the office sector vulnerable."

For Manhattan's sake, let's hope the new year brings a quick recovery.