by JOHN HOLUSHA

The underlying fundamentals of the commercial real estate market in Manhattan are behaving in the mirror image of expected patterns.

Financial industry companies continue to cut jobs and the dot-coms and telecommunications companies are a fraction of what they were. Because of this shrinkage of the work force, companies are offering unneeded space for sublease at discounted rates, adding to the forces that are depressing overall rent levels.

According to figures compiled by Julien J. Studley, a brokerage that represents tenants, the average asking rent for prime buildings in Midtown has fallen to an average of $67.55 a square foot compared with $75.48 per square foot before Sept. 11, 2001. And, it notes, because of better terms being offered by landlords, deals can be made with effective rents of about $60 a foot. Effective rents downtown are about half of those in Midtown, the company said.

Since occupancy rates and rent levels create the cash flows that underwrite the value of properties, sales prices usually move in parallel with a leasing market. When vacancies are low and rents high, prices rise; when vacancies are high and rents are dropping, prices decline.

Not now. With many investors moving their money out of the stock market and into what is perceived as the comparative safety and stability of real estate, buildings in Manhattan have been fetching record prices. The decision by Boston Properties, a real estate investment trust, to pay $1.06 billion, or $630 a square foot, for the building at 399 Park Avenue, between 53rd and 54th Streets, was cited by many real estate executives as an example of the exceptional demand for prime properties.

Although leasing fundamentals are currently weak, they can be expected to improve with a recovery of the overall economy, real estate specialists say. Meanwhile, capital is moving out of the stock and bond markets looking for a safe haven in real estate. "I get calls every day from people who want to lend me money," said Leslie W. Himmel, a partner in Himmel & Meringoff Properties, an investment company.

John Lyons, the president of Granite Partners, a New York-based real estate finance group, said: "There is tremendous uncertainty in the equities market that is prompting people to look for hard-core assets with a steady income stream from long-term leases. There is tremendous demand for Class A properties in central business districts."

Many real estate executives say they fear the current level of demand for office space is not yet at the bottom of the cycle. They do not expect a recovery until most of the sublet space is absorbed and the leasing market returns to a more normal condition, possibly by early next year.

"I don't think we are on the way up yet, but we're not far from the bottom," said Stephen B. Siegel, chairman of Insignia/ESG, the brokerage and services company. "The wave of sublet space creates uncertainty about rents because 75 percent of it has no asking price."

Sublet space can be a smart alternative for a company that does not want to make a large capital expenditure in uncertain economic times, because the space is usually fully built out and equipped for use. Companies moving into space being marketed directly for a landlord usually have to pay most of the expense of converting raw walls and floors into usable offices.

"Say we are looking for 60,000 square feet of direct space downtown for a client," Mr. Siegel said. "You could make a deal in the high $30's or low $40's and get some modest contribution to work from the landlord. But you would still have the capital expenditure for the buildout.

"But you could sublet for $25 a square foot with fully built-out offices and a phone system," he said. Subleases tend to be of shorter duration than direct leases, but a short-term solution that conserves cash in uncertain times may be just what some companies are looking for, Mr. Siegel said.

This may be especially true of space once occupied by dot-com companies, which lavished money to turn space in old, poorly equipped buildings into locations suitable for doing business on the Internet, said James S. Meiskin, president of Plymouth Partners, a tenants' broker. "The dot-coms poured millions into their spaces," he said. "There is a lot of demand for highly improved dot-com space."

Mr. Meiskin said space once occupied by failed or greatly shrunken Internet and telecommunications companies has swelled the amount of sublet space available to the point that sublet space is 35.6 percent of the total on the market. Typically, sublet space runs in the single digits of the total.

Because companies seeking to sublet space are trying to reduce the cost of their lease obligations, he said, they are willing to price the space lower than the primary landlord, to get a paying subtenant in as quickly as possible. "The owners feel pinched because the sublease space is priced below direct space," Mr. Meiskin said.

In addition to the dot-com and telecom spaces, which tend to be in older Class B or C buildings, vacancies in Class A space Ü the most-modern, best-located properties Ü have increased in the current quarter, according to figures complied by the Studley firm. The Class A vacancy rate in Manhattan was 10.7 percent at the beginning of this month, up from 7.8 percent at the end of June, as 1.64 million square feet was added to the rolls during the period.

There is now approximately 13.2 million square feet of vacant Class A space in Manhattan, divided almost equally between Midtown (6.86 million square feet) and downtown (6.34 million square feet.) Much of the recent increase has been concentrated in Midtown, according to the Studley figures. There was 3.64 million square feet of Class A space available in Midtown before Sept. 11, 2001. That increased to 4.82 million square feet in the second quarter of this year.

Nevertheless, these Class A spaces are likely to attract tenants more quickly than the older Class B and C properties, said Mitchell Steir, vice chairman of Studley. "The best quality product will always lease first, even if the number is a little lower than the owner would like," he said. "An example is the Times Square Tower, where all the Andersen space should be leased by the end of the year."

The accounting firm of Arthur Andersen was to have been the anchor tenant in the building now under construction at 42nd Street between Broadway and Seventh Avenue. But then the firm was enmeshed in the financial scandal surrounding the Enron Corporation and is being dismantled.

Some brokers are suggesting that this is a good time for companies to lock in leases while rates are near their cyclical lows. "We have seen real estate cycles where tenants have subsidized their business by signing 15-year leases near the bottom of the market," said Michael T. Cohen, president of Williams Real Estate.

He said this particularly applies to downtown, where a combination of a soft market, willingness of landlords to negotiate and government incentives have made rents far lower than in Midtown. According to Studley, the cost gap between the two submarkets has grown substantially. Midtown costs, which were 64 percent higher than those downtown on Sept. 11, 2001, are now twice as high, by Studley's estimates.

Mr. Cohen said the buildings of the World Financial Center, which were close to the World Trade Center and damaged in the attack, represent particularly good bargains. "The World Financial Center is some of the best real estate in the country with some of the best urban planning since Rockefeller Center," he said. The buildings are "such a howling bargain," Mr. Cohen added, that they are filling up again.

But other properties downtown are much harder to fill, many brokers report, because of the lingering transportation problems, the questions about what will happen at the Trade Center site and the emotional aftermath of the Sept. 11 attack. "People kick the tires downtown" but are not quick to commit to relocating there, said Patrick Robinson, managing principal in the New York office of the Staubach Company, a tenants' broker. "In a down market, tenants will go to quality," he added. "As rents come down and spaces become available on Sixth and Park Avenues, that's where people want to go."

"Midtown is the preferred location," said Francis A. Doyle, managing director of the New York office of Jones Lang LaSalle.

The low sale price of an interest in one of the buildings in the World Financial Center last week is indicative of the difficulties in Lower Manhattan. Brookfield Financial Properties, the successor to the company that developed the center, paid $127 a square foot for a 51 percent interest in 3 World Financial Center, as compared with sales prices of several hundred dollars a square foot for major buildings in Midtown.

Many real estate executives say they expect the office vacancies to drop and rents to increase in a fairly short period if the economy improves, because there has been little new construction and what has been built has been for specific tenants like Reuters and Ernst & Young in Times Square. "There has been no speculative building, so the market could tighten up quickly," Mr. Meiskin said.

But some argue that there is more office space overhanging the market than is generally recognized. Old industrial buildings on the West Side of Manhattan that have been converted to office use are just as much a part of the market as shiny new towers, they argue.

One adherent of this school is James B. Buslik, a principal of Adams & Company Real estate, a brokerage. "Between 14th Street and 40th Street on the West Side there have to be 100 buildings of 50,000 to 200,000 square feet that have been converted from industrial to office," he said.

Just listing a few of the giants Ü 111 Eighth Avenue, a former Port Authority terminal; the Starrett-Lehigh building at 601 West 26th Street; and Chelsea Market at 75 Ninth Avenue Ü quickly produces impressive space totals. "You can get to 8 million square feet with just five buildings, and you can add the whole Trinity portfolio to that," Mr. Buslik said, referring to the properties owned and managed by Trinity Church, which have largely been converted from industrial uses, such as printing, to offices over the last decade.

"People say there has been no new construction, but it has been reconstruction that has added to the supply," Mr. Buslik said. "Those buildings are not going back to manufacturing; this is not a manufacturing city any more."

Although brokers tend by nature to be optimists, some will admit that the prospects for the office market in Manhattan are clouded. Job shrinkage in the financial services industry means less space is needed to house workers, and the accounting scandals have made many companies reluctant to make real estate decisions, they say.

"We are going to be in the doldrums for a while," said Mark P. Boisi, chairman of Colliers ABR, a brokerage. "We have not seen the last of the layoffs yet, and we have not seen the last Enron. Have we hit bottom? I don't know, but I suspect the next few months will tell."

But if prospects for office leasing are uncertain, the investment sales market is quite clear. Investors like real estate in New York and are willing to pay to buy it. In paying $630 a square foot for the building at 399 Park Avenue, Boston Properties well exceeded the per-square-foot price paid for trophy properties in the recent past.

According to Robert L. Sammons, director of research for Colliers, the Seagram Building at 375 Park Avenue sold in late 2000 for $519 a square foot. Earlier, in August 1998, the General Motors Building at 767 Fifth Avenue was sold for $439 a square foot.

The lowest interest rates in decades make it relatively easy for buyers to finance purchases, and the gyrations of the stock market are driving investors to the stability and predictability of real estate. "Investment sales seem to be responding to the capital markets rather then the rental market," said Mr. Cohen of Williams. "The assumption is that, while rentals are sluggish, economic expansion will resume in the future."

Bruce Mosler, the president for United States operations for Cushman & Wakefield, the brokerage and services company, said: "There is a flight of capital from the stock market to real estate, and prices are increasing. The problem is there is a dearth of quality product."

The ultralow interest rates mean that buyers may not have to wait for the leasing market to improve to start making money, Mr. Lyons of Granite Partners said. This is because, recently, some buildings immediately produce a greater percentage return than it costs the buyer to borrow. For example, if a building produces an 8 percent annual return on investment, and the buyer can borrow for 6 percent, the buyer pockets the 2 percent spread between borrowing cost and income. "People can make millions on the spread, which is why it is very beneficial to buy buildings at this time," he said.

In a research note on Boston Properties issued in connection with the purchase of 399 Park Avenue, David Shulman and Stuart Axelrod, securities analysts with Lehman Brothers, raised earnings expectations for the REIT as a result of the transaction. They noted that 75 percent of the building's 1.6 million square feet are leased for 15 years at rental rates slightly above the current market.

"The interest rates today make what might have been a marginal deal look like a great deal," said Peter Hauspurg, the chairman of Eastern Consolidated Properties, a sales brokerage in New York.

Regional Trends: A Similar Pattern To Manhattan

Demand for office space in the areas around New York follows the same pattern as in the city: vacancy rates are rising and rents are declining.

In Jersey City, where the Class A space is a clear alternative to Manhattan, the vacancy rate increased to 14.2 percent at the end of the second quarter from 12.9 percent at the start of the quarter, according to estimates by Colliers, , while the average rent declined to $29.43 a square foot from $32.56 a square foot.

The vacancy rate in Class A space in Westchester County rose to 14.9 percent on June 30 from 13.9 percent at the beginning of the second quarter and from 8.9 percent at the end of 2000. However, asking rents held steady, at an average of $26.08 a square foot.

Layoffs in Fairfield County placed more space on the market than could be absorbed, with the vacancy rate spiking to 16.8 percent at the end of the second quarter from 11.2 percent in September 2001, according to the Colliers study. Average asking rentals for Class A space declined slightly, to $29.65 a square foot.

As in Manhattan, sublet space has become an important factor in Westchester and Fairfield Counties, said John D. Goodkind, managing principal of Newmark & Company Real Estate's Westchester and Fairfield office. "Sublet space is about 25 percent in Westchester and about a third in Fairfield," he said. "These markets mirror what is happening in New York."

Retail Space: Shopping Areas Remain Attractive

Demand for retail space has held steady in most parts of Manhattan this year, despite the decline in the office sector, according to brokers specializing in such space. "The luxury brands are still flocking to Fifth Avenue," said Robert K. Futterman of Robert K. Futterman & Associates. He noted that Boucheron, a subsidiary of the Gucci Group , leased a space in the St. Regis Hotel at Fifth Avenue and 55th Street to sell high-end jewelry, perfume and watches. And De Beers, the diamond merchant, has said it will open its first United States retail store in 2004, also in the St. Regis.

Other areas in Manhattan's traditional shopping districts have been attracting attention as well, said Alan Victor, an executive vice president of the Lansco Corporation. "There is a space available on the northwest corner of Madison Avenue and 57th Street with about 3,300 square feet on the ground floor and mezzanine levels," he said. "The asking price is $1,000 per square foot for the first floor and $250 a square foot for the mezzanine, and they have already had several offers."

And the interest is not just along the Gold Coast of upper Manhattan. Although some stores in SoHo closed after tourist traffic dropped off after the attack on the World Trade Center, "the death of SoHo has been exaggerated," Mr. Futterman said. "The international tourist has not come back to SoHo, but the local tourists have," he said. "People from suburban New York, New Jersey and Connecticut are much more comfortable about coming back to SoHo."

Hotels: The Customers Are Less Well-Heeled

New York's hotels are fairly well occupied now, but with a lower-priced crowd that is keeping average room revenues substantially below the levels of before Sept. 11, 2001.

"We have lost a lot of high-rate business travelers," said John A. Fox, senior vice president of PKF Consulting, a company specializing in the hospitality industry. He said many international business executives had been reluctant to visit New York and the economic downturn domestically made many businesses curb travel or opt for more modest lodgings.

The result is that the occupancy rate of 73.5 percent for the first seven months of this year was just slightly below the rate of 75.3 percent for the corresponding period in 2001, according to PKF's figures. But the average room rate for this year was $183.67 a night compared with $207.28 in the same period last year.

"Demand is reasonably strong, but the market mix has changed," said Arthur Adler, managing director of Jones Land LaSalle Hotels, a brokerage and consulting company. "Airline and hotel promotions are bringing in more of a leisure business than corporate expense account business."

He said the outlook was for more of the same, until the economy rebounds. "Room rates will be difficult to recover until the corporate market develops more confidence in the economy," he said.