Office market sees rent growth evaporating

NEW YORK (Reuters) - U.S. office rent growth stalled in the second quarter and vacancies crept up, a trend that could portend rising loan defaults in the commercial real estate market, according to a report by real estate research firm Reis.

U.S. office rents grew just 0.7 percent in the second quarter when factoring in concessions, less than half the 1.5 percent posted in the first quarter and far slower than 3.2 percent a year earlier.

"In inflation-adjusted terms, both asking and effective rent growth have stalled," Reis chief economist Sam Chandan said.

The U.S. office vacancy rate ticked up 0.2 percentage points for the second consecutive quarter to 13 percent, its highest in more than a year.

"The vacancy rate isn't skyrocketing, but there's enough nervousness (by tenants) that there's some hesitation to make a longer term commitment, which is why you see that -- in spite of the vacancy rate being very low and despite the increase in the vacancy rate being quite modest -- the gains in rents have evaporated," Chandan said.

At an annualized rate, rents are growing just 2.9 percent, a fraction of the 10.6 percent seen last year.

Although the weakening rental rates and rising vacancies are modest compared with the downturn after the dot.com bust, they could lead to the failure of many investments made in the past one or two years.

"On the investment side, this is extremely problematic because of the extent to which these properties have been leveraged and the much higher underwriting standards that will have to be met in the future," Chandan said.

For example, in New York, the largest U.S. office market, rental rates grew 7.8 percent in the second quarter and 25 percent for the year. But in the second quarter of 2008 that growth slowed drastically, to 0.7, translating to an annual rate of just 5.2 percent.

Many of the prices paid last year for property were based on the assumption that strong rent growth and low interest rates would continue. On paper, that provided the investors with funds to eventually cover monthly mortgage payments and a big increase in value when it came time to resell or refinance the loan to repay the principal.

"These are issues that will present challenges to the market in 2008 and also in 2009 and 2010," he said.

While effective rent grew just 0.7 percent, asking rent was up 1.1 percent, meaning landlords were forced to throw in concessions to attract or retain tenants, Chandan said.

Second-quarter effect rent, which includes months of free rent and allowances for improvement, grew to just $25.15 per square foot, the smallest increase since the second quarter of 2005. Asking rent was $29.34 per square foot.

Of the 79 U.S. markets that Reis tracks, Seattle saw the strongest effective rent growth during the second quarter, up 2.8 percent to $27.46 per square foot. While Lexington Kentucky saw the greatest decrease, down 1.9 percent to $13.85 per square foot.

Las Vegas saw the greatest rise in vacancies, up 3.2 percentage points in the second quarter, to 17.3 percent. Charleston, South Carolina, saw the greatest vacancy decline, down 1.5 percentage points to 12.6 percent.

(Editing by Andre Grenon)