By Hans Nordby

Despite 10 consecutive quarters of GDP growth and corporate profits at an all-time high, there are still more than 2 million fewer people working than in early 2000. This dearth of jobs is at the heart of why vacancy rates in the U.S. office market have risen to uncomfortably high levels over the last three years, and a key reason why office REITs often trade at discounts to their retail, warehouse and apartment REIT counterparts.

Does this lack of job creation make any sense? Will we escape the jobless recovery, start hiring and fill office buildings? If we are poised for a rebound, does that make office REITs an interesting investment alternative? The answers are all a resounding "yes."

At the beginning of an economic downturn firms lay off workers and reorganize operations to do more with less. Those workers left with jobs are carrying heavier burdens and are working hard to hold on to their jobs. As a result, productivity skyrockets just as employment plummets, along with the demand for office space.

Fortunately for office building owners, there's a positive side to economic cycles as well. Productivity can only expand for so long before workers simply can't do any more. As the economy and corporate profits recover, firms must hire in order to grow profits further. At first, companies take on temporary workers to avoid the commitment of permanent hiring. Thereafter, as unemployment declines, firms offer permanent positions in order to hang on to their labor force. Ultimately, the temporary and permanent jobs created result in new office leases about two quarters after the workers are hired. People call the beginning of this pattern a "jobless recovery" and worry that job growth will never recover. That's silly. This pattern is part of a regular economic cycle.

Time to Staff Up

Source: U.S. Bureau of Labor Staistics; PPR

As shown in the chart on the next page, this pattern is exactly what occurred in the early 1990s recession and subsequent recovery. Employment growth (the red line) declined for nine consecutive quarters just as productivity (the blue line) posted solid gains. At the same time, annual absorption of office space in the 54 markets Property & Portfolio Research (PPR) tracks nationally declined from 141 million square feet in 1989 to only 58 million square feet in 1992, before averaging 107 million square feet per year from 1993 through 2000.

The most recent economic downturn has exhibited the same relationship between employment, productivity and office absorption, but on an even more dramatic scale. About 2.4 million jobs were lost between April 2001, when employment peaked, and year-end 2003. During the same period, productivity growth skyrocketed, from less than 2 percent to over 5 percent, on a four-quarter rolling average basis. Concurrently, office space absorption fell from 142 million square feet in 2000 to a negative 117 million square feet in 2001, before recovering tepidly in 2003 to a still-weak 28 million square feet.

PPR is forecasting this economic cycle to continue normally, with office absorption popping to 116 million square feet in 2005, and then falling slowly through the end of our forecast period in 2008.

For investors, this indicates office REITs with relatively high portfolio vacancy rates or heavy lease rollover in 2004 and 2005 could fare much better than many stock analysts expect. That said; beware of where the REITs have leasing exposure. Not all metropolitan areas will gain jobs, and therefore absorb office space, to the same degree. In other words, this recovery story is much more relevant in Phoenix, where employment growth is already stellar, than Hartford, where job growth is expected to languish.

Also, many REITs have portfolios full of leases signed during the boom times of 1998 through 2000, at rents much higher than today's levels. Those REITs could suffer substantial rent roll downs as those leases expire, hurting them as much as occupancy gains help.

Hans Nordby is a research strategist with Property & Portfolio Research.