If you would like to save a PDF version of this, click here.

In the third quarter of 2007 the Northern Nevada office market returned to the trend line of ever increasing vacancy. After taking a brief reprieve during the second quarter, the total market vacancy increased to 17.9% from 16.9% last quarter and 17.4% at the beginning of 2007. Sublease space continues to be a thorn in the side and will continue to pose a major threat to the market. The market vacancy would be 19.7% if it were calculated including the available sublease space. The availability of a large amount of direct lease and sublease space coupled with light tenant demand continues to impede the office market. This trend is expected to continue into the second quarter of 2008. Class A office space continues to hold the position as the strongest classification with the lowest vacancy rate. Class A properties finished the quarter with vacancy rising to 12.4% from 11.7% at the end of the last quarter. Although Class A remains strong in direct vacancy the group has the highest percentage difference in vacancy including sublease space. The classification vacancy would increase over three percentage points when calculating all space currently on the market for both lease and sublease. Value tenants and tenants retracting from Class A suites helped reduce the vacancy in Class B office product. Overall vacancy in Class B dropped slightly to finish at 22.9% down from 24.7% and was very minimally impacted by sublease availabilities. Class B vacancy with sub-lease space included would only increase to 24.1%. Garden product remained statistically flat at 22.3% and 22.5% with sublease space included in the third quarter.

Average asking rental rates dropped slightly in the third quarter of 2007 as a result of increasing vacancy and increasing sublease space. This is in direct contrast to the national trend for the year of increasing effective rental rates. Tenants are in control of the market and have strong bargaining power. The few tenants who are actively searching for space are in a great position to secure space at reduced rental rates and with additional concessions. This also holds true for tenants looking to renew or extend current lease agreements. The average asking rate for class A product in the third quarter was $1.96 per square foot per month and class B was $1.56 per square foot per month. Landlords winning tenant’s business continue to provide concessions. The norm seems to be assistance with tenant improvement related expenses, but recently we have seen free rent become a negotiating chip. Tenant improvement expenses continue to average at historical highs above $60 per square foot when starting with shell space for a basic build-out and expenses of higher end office improvements are above $100 per square foot. Tenant improvement expenses for specialty uses, such as medical and dental, are commonly above $150 per square foot. These are real dollars that must be accounted for in the transactions and most tenants are unwilling to spend substantial dollars to acquire leasehold rights to a suite in the current market conditions.

Land costs slipped slightly in the quarter to finish down in a range of between $10 to $16 per square foot. The reduction is a direct result of reduced demand for development land with the increase in vacancy. Land holders are looking for ways to maximize the value of their holdings, yet developers are unloading unnecessary land. Construction costs remained steady and a survey of commercial general contractors doesn’t indicate and easing coming soon. Most contractors had expected some price reductions in materials and labor expenses with the slowing in the residential market, but haven’t seen this become reality. The minimal reduction in land pricing has not improved the economics for developing new projects. It is still very difficult to make a project work economically without securing a tenant or tenants prior to the start of the project and the required lease rates from those tenants to make a project work are still above competitive rental rates.

Class A office construction has continued to slow. The only start in the quarter of any significance is the 80,000 square foot build-to-suit for Employer’s Insurance Group on Professional Circle. Most other projects have come to completion or are nearing completion. All other major projects remain on hold until inventories are reduced or pre-leasing efforts are successful. Planned garden office projects of nearly 350,000 feet are still planned or in some stage of construction, yet the total square footage is unlikely to be completed within the next year or if ever.

The Meadowood Submarket continues to be the leader of the submarkets with the lowest vacancy rates. The submarkets overall vacancy finished the quarter down at 13.4% from 13.9% at the end of last quarter. With the adjustment for sublease space the submarket would finish at 14.6%. Class B product vacancy in the submarket dropped to 21.7% from 23.2% while Garden product vacancy continued to creep up and finished at 17.6% versus 17.1% at the end of the second quarter.

The South Meadows Submarket is the most diverse of all markets. The sublease problems of the whole market are magnified in this submarket and may be an example of what could come for the market as a whole. The all classification vacancy finished up19.7% from 16.4% in the last quarter. This is primarily the result of some sublease spaces being converted to direct for lease product. Even with the increase, the overall market vacancy would be 24.3% if the sublease space was included placing this submarket amongst the markets with the highest overall vacancy. Class A product showed the biggest change with vacancy rising up nearly four percentage points to 18.1%. The vacancy rate jumps to just under 26% when including the sublease space available. Garden office product which was the bright spot of this market in the last quarter also turned for the worst. The addition of new product and continued difficulty in leasing this type product in the submarket increased vacancy to 26.7% up from 23.9% at the end of the last quarter. The amount of space available in this submarket should remain high for at least the next year and depending on economic conditions may last further.

The Downtown submarket has been a huge success thanks to the redevelopment agency, the City of Reno and the brave investors who believed in the market when few others did. The submarket has rebounded extremely well from a few years ago when it seemed that all the tenants were looking to relocate to the south part of town. Today, the submarket is one of the strongest in the area and continues to draw the attention of tenants from both our market and abroad. The all classification vacancy finished the quarter slightly up at 16.9% versus 16.3% last quarter and remained minimally impacted by sublease space. Class A product had another strong quarter and finished at 11.7%. Class B remained statistically flat at 24.9%. We feel this market will continue to perform well as the buzz about downtown continues to catch the ears of tenants.

Investors looking for opportunities in the Northern Nevada market may have found their time. Even with investment demand remaining relatively strong, some sellers are willing to dispose of properties at prices lower than we have seen in a few years. Asking prices continue to be based on capitalization rates of between 6.5% and 7.5% but transactions are being completed at higher rates. Class A product with strong tenants still demand close to a 7% capitalization rate, yet lesser product or product with some deficiencies are being sold closer to an 8% cap rate and in some cases higher. Look for the uncertainty in the overall economy to continue to reduce prices and create buying opportunities.

NATIONAL OUTLOOK

The turbulent times in the residential real estate market haven’t resulted in trouble for investors on the commercial side of real estate on a national scale. Dollars pouring into Investments are still strong led by some large transactions in the national office market. A total of nearly $400,000,000,000 in commercial property sales nationwide through the third quarter of 2007 is ahead of the record pace of last year.

In comments by Treasury Secretary Henry Paulson he described the residential real estate market and the related subprime mortgage issues as “the most significant current risk to our economy,” yet most economists tracking commercial real estate see a return to a normalized market from the overheated market we have experienced for the last four years. This does mean a slowing, but predictions are nothing close to the defaults and foreclosures occurring and expected to increase in the housing market.

The national commercial market has and should continue to weather the storm better than the residential market as a result of three main factors. The first is that the commercial market is not seen as overbuilt while the residential market is believed to be overbuilt and thus compounding the problems of lack of funds and buyers alike. The second is that the national commercial markets remain strong. Effective rents continue to climb and occupancy levels remain strong. The final factor is that most commercial property owners and developers are more experienced in the financial markets and thus understand risks better, and have much greater holding power than home owners and residential speculators.

Posted by Tom Reid / Newsletters