Among the more intriguing plot lines waiting to be played out in the Philadelphia real estate market is the future of Cira Centre after the Keystone Opportunity Zone (“KOZ”) benefits expire at the end of 2018. In creating these tax advantaged zones, the Commonwealth of Pennsylvania and the City of Philadelphia hoped to create thriving business communities in otherwise blighted areas. Clearly this strategy worked in West Philadelphia as University City has quickly become one of the most dynamic submarkets, in part due to the economic stimulus provided by Cira Centre and its high end office tenants. However, the businesses that originally came to Cira for the substantial KOZ benefits will soon have to decide if they really love West Philadelphia and, if so, the rental rates they are prepared to pay once they have to start paying taxes.
To be clear, not every tenant in Cira Centre (or the Navy Yard for that matter), was motivated to move there because of the tax benefits. Some chose not even to qualify for them. Some tenants located there because of the quick access to 30th Street Station and the easy commute up the northeast rail corridor. These tenants may be unaffected by the passing of the tax benefits. However, most of the original tenants in terms of square footage were initially drawn to Cira for the material benefits and clearly agreed to pay premium rents because of the KOZ savings.
A Little History
Back in 2003-2005 when many of the original leases for Cira were executed, the downtown office market was very weak and opportunities existed for tenants to negotiate very aggressive lease deals. Because Cira was a new building, Brandywine Realty Trust, the developer of Cira, needed to obtain hefty “replacement cost” rents to justify its material investment in the new project. Again, because of the tremendous tax savings, many Cira tenants ultimately agreed to pay $10-$15/sf rental premiums over what they could have paid for Class A and trophy buildings on West Market Street in order to sign on in the new building. For some, the tax benefits more than offset the rental premium and on a net basis it made economic sense to move to West Philadelphia.
What Happens Now?
Common sense tells you that if and when the valuable tax benefits disappear in 2018, tenants will not be willing to pay the same rents at Cira. In fact, some may not be willing to stay in Philadelphia at all if they now have to pay taxes. However, things are a little different now than they were when these original leases were first executed and that may work in Brandywine’s favor.
Today, the Center City market is tighter– especially in the trophy sector of the Central Business District. The $10-$15 premium that Cira was commanding over Class A and trophy product on West Market Street has shrunk as downtown office rents have steadily risen over the past few years. To the extent tenants liked the Cira location and building but needed the tax benefits to justify or offset the rental premium, these tenants may not need as much of a subsidy any more. However, even if cheaper options in the Central Business District exist, it may not be easy to move there.
When Brandywine first committed to building Cira in 2003, they owned no assets in Center City. Today, only 12 years later, well over 30% of their total company revenues come from Philadelphia and they are now the largest office building owner in the City. If and to the extent the tenants of Cira, who are now accustomed to modern, trophy office tower living, want to move out after 2018, where will they go? Unfortunately for them, their choices in Center City may be limited. Brandywine now owns all but three of the downtown multi-tenant trophy office towers (One and Two Liberty and Mellon Bank Center) and, therefore, control most of the likely move alternatives. Limited move options mean limited competition which could impact the pricing for any renewal at Cira as well as any move. When it comes to the high end of the Center City office market today, it might as well be called “Brandyville”.
For those tenants looking to minimize their taxes or otherwise find cheaper real estate options, they may look to New Jersey with their aggressive tax incentive programs, the Philadelphia suburbs, or even the Navy Yard or Drexel’s Innovation Neighborhood if they can obtain extensions of their KOZ status in a new zone. Others may simply move to one of a number of Center City Class A office buildings with rents below $30/sf.
In sum, come December, 2018 we will see if the KOZ legislation created only a temporal fix for a “down on its luck” neighborhood or a long term panacea. Are the tenants there because they pay no taxes are or have they learned to love University City and the easy rail access? If the former, they will leave, if the latter, whether they leave or not will simply be a matter of what the rent is. If and to the extent Cira is able to retain its tenants or attract new ones to replace those who depart, University City will remain a thriving submarket and the KOZ legislation will have been a success. However, if the City loses jobs because the original tenants flee to the suburbs or New Jersey, we may be forced to re-evaluate these policies.
The Navy Yard
What happens at Cira will be magnified at the Navy Yard when the different KOZ periods expire. While Cira is now almost part of Center City, given all of the recent development there, the Navy Yard is much more remote. It’s a whole different market without the amenity base of University City or the access to public transportation at 30th Street Station. On the other hand, Liberty Property Trust, the master developer of the Navy Yard, has done a wonderful job creating a very unique business environment that isn’t trying to be Center City. Again, not every tenant at the Navy Yard is benefiting from the tax exemptions– some are there because they like the building product and the cool vibe. However, to the extent tenants are enjoying tax exemptions; will they still want to remain in South Philadelphia once they have to start paying taxes and, if so, at what rental rate?
Conclusion
As the famous lyrics from “Que Sera, Sera” tell us, “The future’s not ours to see.” That said it’s certainly interesting to speculate about what may happen when it comes to Cira in 2019. As job creation becomes more and more of a hot button topic in business circles, we will anxiously await the decisions of area CEOs who are faced with looming tax burdens. Are they here because they aren’t paying taxes or have they grown to love the City (or Navy Yard) and are here to stay? Ultimately the answer to this question could come down to price. Brandywine and Liberty are surely hoping that the premium rents they are currently collecting will not be negatively impacted. However, the tenants will ultimately hold the cards in determining what will be. Que Cira Cira.
For more information contact Glenn Blumenfeld