Center City office rents seem to be stabilizing and large blocks of contiguous space are becoming few and far between. Generally speaking, landlords are feeling better than they were in 2005-2006 when over 4,000,000sf of availabilities existed in the trophy market alone. Is this a sign that business is picking up in Center City or is something else going on?
Unfortunately, things are not quite as good as they appear. The firming up of rents and lack of availability of large blocks of space are due more to the removal of office inventory from the market than to the influx of new business and expansion of existing businesses in the Central Business District (CBD). Since 2005, over 300,000sf of trophy space at the top of Liberty Place 2 was converted to residential condominium space. More recently, 2040 Market, 260 S Broad, and 1616 Walnut Street, among other buildings, are being converted to high end residential rental units and there are even rumors that some Class A office building owners are starting to think about converting floors in their buildings to residential apartments as that market segment continues to heat up. In sum, office inventory is disappearing thereby driving supply down.
Why is office space being converted to alternative uses? While it is true that some companies in Center City are growing (Comcast, FMC, and certainly our area universities and health care systems), many are shrinking or have left the CBD all together. Arkema and Lincoln Financial, among others, have left the city; Sunoco was sold and continues to shrink its city presence significantly; Unisys never moved into its space at Two Liberty even after signing a 90,000sf lease; and GlaxoSmithKline will be leaving the CBD and calling the Navy Yard its home this spring. The majority of large law firms, historically the largest consumers of CBD office space as an industry group, believe that their future growth will not be in Philadelphia. Many have excess space in the City even after consolidating their former suburban offices into their downtown headquarters. That means firms like Ballard Spahr (2 floors in Mellon Bank Center), Reed Smith (in their move to Three Logan) and Drinker Biddle (2 floors in their renewal at One Logan) have shed or will be shedding considerable space when their current leases expire.
Even companies who remain in the CBD and who are not downsizing are consuming less square footage per employee as they become more efficient consumers of space and adopt hotelling and telecommuting policies. This trend further reduces overall demand for space and is of concern for building owners nationwide.
With demand for office space in the CBD shrinking, buildings that suddenly face major vacancies and, therefore, significant reletting costs, are starting to evaluate alternative uses for their spaces that can generate larger returns. Whether or not these repositioning strategies work out for the owner, they have the incidental benefit of tightening the overall office market and, therefore, enhancing the values of other office buildings in the CBD.
What does all of this mean for tenants?
1. A flight to quality. As is usually the case in real estate markets where supply outstrips demand, there is a flight to quality by tenants. When 4,000,000sf of vacancy was concentrated in the trophy towers in 2005-2006, those trophy landlords lowered their rents and offered rich concession packages to attract tenants from Class A, Class A-, and lesser quality buildings. The rent differential became so small that tenants made the move up in quality without materially impacting their bottom line, especially since many gained space efficiencies in their moves. The Class A and A- landlords then lowered their rents to attract tenants from the Class B buildings in order to fill their resulting vacancies and retain their well courted tenants. When the dust settled, the lesser quality Class B and C office buildings were near empty and their highest and best use was no longer as office buildings. They logically converted to condos and residential rental units, thereby contracting the overall office inventory. As rental rates reflect the balance of supply and demand, the shrinking inventory had the effect of stabilizing rental rates in the city even as demand in the CBD was actually shrinking. The same conversion phenomenon is happening today.
2. A repositioning of one or two major assets can materially impact the market. Imagine what will happen to Center City office rents if Franklin Plaza and 1900 Market Street are repositioned as Class A office buildings with almost 1,000,000sf of availability. While Brandywine just publicly committed to renovating 1900 Market into a Class A office building, Center City office landlords are certainly crossing their fingers and hoping that part or all of One Franklin Plaza is converted to educational, hotel, or residential use. As these two assets are owned by two of the largest office landlords in the the CBD (Commonwealth Realty and Brandywine Realty Trust), their strategies for these “in limbo” assets will clearly take into account how additional or reduced office inventory will impact the value of their other CBD assets.
For Philadelphia to truly have a healthy office market, it must do more than stabilize rents through asset attrition; it must reverse the trend of job loss by attracting new headquarter operations and making the city a desirable home for businesses. We simply can’t rely on shrinking inventory and our universities and health systems to prop up our real estate market. Simply put, we need more buildings with the names of large, anchor tenants on top of them like Boston, Chicago, Dallas, Houston and Washington, D.C have.
While it is certainly good for real estate owners when rents stabilize, it is important to understand the cause and effect in order to assess the true health and future of the market. Certainly, it is preferable when rents grow and stabilize as a result of increasing employment as opposed to shrinking inventory. The health of our city ultimately is dependent upon our city leaders convincing companies that Philadelphia is the place to grow their business. We need to spur demand and that means rethinking how the city taxes and works with businesses. The signs that Philadelphia has been successful in its efforts will be readily apparent; they’ll be on top of the new buildings.
For more information contact Glenn Blumenfeld