Development aligned with specific tenant demand and improving sectors—particularly the energy, education, medicine, federal government, and biotechnology sectors— presents the best opportunities for office development, office market expansion, and long-term economic growth.

Nine times out of ten, the U.S. office market lags the performance of the overall economy. In the current recession, commercial real estate continued that pattern.

Today, the office sector lies positioned between corporate stagnation and expansion. While office market fundamentals remain bleak, negative trends have decelerated and pockets of stability—and even growth—have formed.

Occupancy levels for the first three months of this year were down for the ninth-consecutive quarter and vacancy hit a record high of 18.5 percent, but the increase in vacancy levels was marginal compared with increases in 2008 and 2009. Further, rents in leading gateway markets also showed signs of hitting bottom. Asking rents in New York City and San Francisco fell less than 1.5 percent for the first quarter after plummeting more than 20 percent last year; nationally, asking rates declined 1.4 percent in the first quarter, compared with a 10 percent drop in 2009.

Meaningful and consistent job growth remains the key factor in the economy’s transition from a psychological bottom to full-fledged recovery, and it will take time, perhaps until the first half of next year, before job growth trends coalesce and corporations move beyond right-sizing and backfilling existing shadow space.

Although sustained growth in occupancy and rents is not expected nationally until the middle of next year at the earliest, pockets of new demand have recently sprouted. Evidence that this could be one of the ten times historically that real estate is a leading indicator has begun to surface recently, and provides some clarity on where growth is likely to emerge over the coming years.

This time around, the economic drivers differ from those of past cycles and are largely aligned with the political landscape of the Obama administration, revolving around priorities related to energy, health care, and a larger government role. The markets that will drive the economic recovery over the next 18 months and set the stage for the next cycle of sustained growth and development are those with a heavy energy presence, such as Dallas and Houston; those with small-cap and biotech clusters, such as the San Francisco Bay Area and Austin; and those with a heavy education, federal government, or medical presence—the “eds, feds, and meds”—such as Baltimore, Washington, D.C., and Raleigh/ Durham. Denver and Pittsburgh, which have components of nearly all these sectors, stand as two of the most intriguing office markets in the country.

Denver benefits from its position as a key market in the growing natural gas and shale gas sectors. Late last year, the Rockies Express (REX) natural gas pipeline began service, for the first time allowing transportation of Rockies gas outside the region—to points as far east as Ohio. As the federal government enacts legislation regulating carbon emissions, demand for natural gas as a clean energy alternative is likely only to increase.

This potential, as well as additional pipeline projects proposed to the west and south of Denver, has led many companies to begin expanding their offices in the market, including Newfield Energy, which has added 66,000 square feet (6,100 sq m) of space in the central business district, and ConocoPhillips, which is developing a 432-acre (171-ha) corporate learning and technology center in Denver’s northwest submarket. Energy companies are expected to continue to expand their footprints in Denver, creating a market with the greatest potential for development activity over the next several years.

For its part, Pittsburgh has diversified from its role as a 20th-century steel town to become a 21st century hub of nuclear and solar research and development, education, health care, and finance. Nuclear energy leader Westinghouse calls the Pittsburgh area home; such local institutions as the University of Pittsburgh and Carnegie Mellon University are growing leaders in computer science, health sciences, engineering, and business; and Pittsburghbased PNC has emerged as one of the country’s top banks. An aging inventory of office buildings and the lack of new development in the past two business cycles, coupled with the numerous industrial sectors expected to generate demand for space, will drive Pittsburgh’s office development activity in coming years.

Regions to watch in next 12 monthsSome of the fastest-growing markets of the past three decades— Las Vegas, Phoenix, south Florida, and southern California—now lag other major U.S. metropolitan office markets. The residential finance crisis that wiped out residential real estate companies, homebuilders, and mortgage companies—and severely hindered the law firms, marketing firms, and other professionals that served them—can largely be traced to the Sunbelt markets. It will take some time for these economies to stabilize and generate new demand. While an uptick in residential pricing can be found in some of these markets, vast amounts of vacant space in recently delivered residential projects will stymie development, capping demand over the next several years. Glimmers of new office demand, such as for biotech in Phoenix and social networking and media in south Florida, have emerged, but wholesale recovery cannot be expected in the next few years.

Los Angeles’s high taxes and strict regulatory environment, coupled with steep labor costs, have created the increasing perception that the city has an unfriendly business climate. In recent years, four major companies have moved their headquarters from the city, including government contractors Northrop Grumman and CSC, auto company Nissan, and hospitality company Hilton, drastically cutting their operations and headcount in the region. The region’s base, the entertainment industry, remains a stable office-market presence. However, with TV and film production increasingly moving to lower-cost locations like Vancouver, Albuquerque, Nashville, and countries overseas, there is little to stop studios from moving finance and other back-office operations to lower-cost markets like Salt Lake City—and minimal effort to date to keep them in California. With massive state and local budget crises threatening to raise the Los Angeles–area tax burden, sustained new demand and development appear increasingly unlikely.

On the East Coast, though the Dow Jones Industrial Average has risen substantially since March 2009, few major financial firms have expanded their New York City office space in recent months. The performance of financial firms, a typical bellwether of demand for office space, is lagging the broader market in the current environment due to pending regulatory reform and debt concerns in the European Union. New construction at the World Trade Center site, an enhanced reliance on the financial services industry, and several other major moves by downtown financial tenants loom over the downtown office market.

Further, both midtown and downtown firms have taken a wait-and-see approach to expanding headcount and thus office space in light of a tougher regulatory environment. In Washington, D.C., the U.S. Securities and Exchange Commission (SEC) recently expanded its headquarters by 200,000 square feet (18,600 sq m) and is expected to add another 100,000 square feet (9,300 sq m) to the facility, pointing to the heightened regulatory environment ahead. If federal regulators require financial firms to decouple derivatives trading from their other operations, Wall Street dynamics and leasing trends could change dramatically. Derivatives drive profits for many Wall Street firms, and removing those profits from the mix could dampen future space demand, prevent rents from rising, and inhibit new development. Another large occupier of midtown space, law firms are adjusting their space needs as they increasingly seek efficient space and a smaller office footprint.

Even though an office market bottom has been reached and a few markets are showing signs of growth, the office sector overall remains challenged as demand and capital market constraints hinder speculative office development—a situation reminiscent of that in the late 1990s. Development aligned with specific tenant demand and improving sectors—particularly energy, biotech, and eds, meds, and feds—presents the best opportunities for office development, office market expansion, and longterm economic growth.

Steps to Commercial Real Estate Recovery