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A few months ago, much of the talk surrounding US real estate was about whether the slowly improving markets might finally escape the long recession's gravitational pull. That hope still exists, but now some worry that sharp budget cuts due to sequestration could foul this tender recovery. The US office market has seen increased activity, but questions remain concerning such issues as the direction of vacancies, values and construction.

“It's holding up pretty well,” Maria Sicola, executive managing director and Americas research head for Cushman & Wakefield, says of the US office market. “We still have vacancy rates that are pretty low and coming down; but they're coming down slowly.”

First-quarter research by CBRE found that “the office vacancy rate fell by 10 basis points as the nation's office markets generally withstood an uneven economic recovery as well as the federal budget sequester. Office vacancy has now declined for 11 consecutive quarters and stands at 15.3%, its lowest level since the first quarter of 2009.”

Sicola agrees that the sequester has not yet had a major impact, except perhaps in Washington, DC, but she points to two other factors that could also limit a recovery. First, job growth was already a bit too slow to fully revive the economy. Second, American businesses continue to search for ways to increase efficiency and shrink their office footprints. These issues “are more important [than sequestration] because they speak to a transformational change in the industry.”

Still, job growth in many cities has not been negligible. For example, MB Real Estate just published its May Market Report, which states: “According to the Bureau of Labor Statistics, Chicago added over 80,000 jobs in 2012, the second-largest yearly gain in employment since before 2003. However, many companies have been right-sizing their leases to accommodate shrinking square-foot-per-employee ratios and space-saving cloud technology.” And since this left many firms with unused space still covered by their leases, even a recovering economy means they can expand without growing their office footprint.

This so-called “shadow space” is “definitely having some impact on absorption,” says Umair Shams, an economist at CBRE Econometric Advisors. In the first quarter, the US office markets absorbed only three million square feet, the weakest rate since 2010 and a big drop from the previous quarter, when they absorbed 23 million, Cassidy Turley researchers found. Vacancy rates remained flat at 15.4% but still about 200 bps higher than pre-crisis levels.

“Fundamentals continue to improve, but the office sector is clearly going through a transformation,” says Kevin Thorpe, chief economist at Cassidy Turley. “Many businesses are reassessing space needs and recognizing they can function perfectly well with a smaller, more efficient footprint. As a result, job growth is not giving the same pop in demand we've grown accustomed to.”

Therefore, the low vacancy rates that cities like Chicago experienced in the late 1990s will remain out of reach for some time, MBRE states. “Instead, in the near term, as start-ups mature and established companies finish re-filling their excess space, we expect direct vacancies to continue their slow, methodical decline, despite the strong demand drivers previously discussed.”

Despite these concerns, C&W, using a somewhat different methodology than Cassidy Turley or CBRE, found that the overall vacancy rate in US CBDs fell slightly in the first quarter to 13%, down nine basis points from the end of last year and 44 from last year. Although many gateway cities had lower-than-average rates, they fell at a slower pace or not at all. Some even increased. The vacancy in Midtown South in New York City, for example, sank to only 6.9%, down 0.14% from last quarter. But rates in San Francisco and Portland rose 0.12 and 0.02 points, respectively, to 8.9% and 10.8%.

According to research on gateway cities by CBRE, “leasing trends softened in these markets amid heightened uncertainty surrounding the impact of federal sequestration combined with tepid economic growth through the end of 2012.” CBRE found that “among gateways, Chicago was the only one with a vacancy decline (-10 bps) in Q1.”

And although results differ from market to market, it also appears that, in general, suburban markets did somewhat better than cities in the first quarter. “In the first three months of this year, suburban markets continued to outpace their downtown brethren,” CBRE noted. “Suburban vacancy fell by 10 bps to 17%, while the downtown rate remained unchanged at 12.4%.”

“The recovery is now taking on a broader scope,” says Shams, and the suburbs simply have more space available and more room for occupancy growth. As an example, he points out that Las Vegas led all markets in the first quarter with an office vacancy rate decline of 120 bps. “This quarter it's been the top performer,” he says, “but it hasn't been in a very long time.” And the desert city's vacancy rate is still 24.6%—more than 1,700 bps above its pre-recession level.

“I wouldn't read too much into it,” Sicola ultimately says of this one quarter of data. The soaring vacancy rates seen in the suburbs during the worst of the recession made them cheap, and therefore, an improving economy, however halting, may cause vacancies to fall faster in these outlying areas. “The suburbs are less expensive, so the ability to make decisions and move on them happens quickly.” And since they have far higher rates to begin with, the suburbs have far more ground to make up.

C&W data show that “in the suburbs, overall rental rates remained relatively flat on both a quarterly and year-over-year basis at $24.08.” Meanwhile, in the CBDs, “average class A asking rents ticked down slightly in the first quarter to $44.56 from $45.17 at year-end,” although rental rates in the CBDs “have risen more than 19% year over year.”

And a long-term problem faced by the suburban market remains. Many corporations, especially in the high-tech industry, that previously set up shop in suburban campuses have continued a migration into the cities to attract younger workers. And companies will go “where the labor force wants to work,” says Sicola, “although it may not be in the CBD.”

Instead, the benefits will more likely flow to the neighborhoods just outside the main financial districts. Sicola points to the booming Midtown South area of Manhattan and Chicago's River North as examples. These areas tend to have older buildings with more brick and less glass and steel, producing an attractive atmosphere to younger workers.

And that first-quarter slowdown in the gateway cities will probably prove temporary as well. In some cities, such as Boston and Washington, DC, it might be a hangover from big fourth-quarter deals, Sicola says. For example, information-storage firm Iron Mountain leased a space last November measuring more than 129,000 square feet at One Federal St., a 38-story office structure in Boston. “The market's taking a deep breath before it springs back into action later in the year,” she says, adding, however, that due to the effects of sequestration, the slowdown in DC will probably continue.

But for all the talk about a too-slow recovery, some geographic sectors and office classes are already quite healthy. Markets in cities that serve the energy industry, such as Houston, Dallas and Denver, are doing very well. And, referring to cities with clusters of high-tech companies such as San Jose, Austin, Seattle and even Pittsburgh, which has a burgeoning tech sector, Shams says, “they've done better in terms of recent demand trends.”

And the long slowdown brought class A office space into the price range of a far wider range of tenants. “The market dynamics are encouraging the flight to quality,” Sicola says. “When the markets are much tighter, you cannot afford class A.” Total leased class A space increased 5.9% since the first quarter of last year, Cushman found, while there was a drop of 8.7% for class B and C space.

What everyone wants to know, however, is when will we see a truly healthy office market? “We're probably looking at sometime in 2014,” when the market passes a tipping point, Sicola says, although some cities will remain low performing. By then, “shadow space will be at a point where it's not really affecting absorption,” says Shams.

“There's always an exogenous factor that could derail a recovery,” Sicola cautions. But for now, “fundamentals are pretty solid.”

“All of the numbers, like jobs and retail sales, are improving,” says Hessam Nadji, managing director, research and advisory services, for Marcus and Millichap. “The sequester [and other factors out of Washington, DC] have formed a headwind. But going forward it's more a case of robbing from a growth rate that would have been stronger than 2012; it's not putting us on track to go backward.”

This seems consistent with the first-quarter findings from CBRE, which conclude that “due to the sequester, we expect further cutbacks in federal and state spending in the coming quarters. These cuts will likely only slow total employment growth—not stop it. As a result, office occupancy should continue to improve for the remainder of 2013, albeit at a slower pace than last year.”

The National Association for Business Economists just released its May 2013 NABE Outlook, a survey of forecasts from 49 economists. It found that NABE panelists estimate 2.4% growth in real GDP from Q4 2012 to Q4 2013 and suggest an improvement in real GDP growth to 3% in 2014.

“We do see that light at the end of the tunnel,” says Sicola. “It's been a slow, steady climb, but we're nearly there.”