When Will Philadelphia Get Some New Office Buildings?


In the past 22 years, we have seen very few construction cranes in Center City Philadelphia for new office tower construction.  The late 1980s and early 1990s saw the development of One and Two Liberty Place, Bell Atlantic Tower (now Three Logan), The two Commerce Square Towers, Two Logan, and the Blue Cross Building. Since then, however, only three new Class A Towers have broken the skyline in Center City, and none were pure real estate deals justified by prevailing market conditions.

Comcast Tower, constructed in 2006, was built for Comcast despite the fact that there was over 3,000,000 sf of Class A office vacancy in the market when the tower moved forward. Comcast wanted a new corporate tower to help define its culture and brand, and its two logical locations were New York City and Philadelphia. Though the $40/sf rents at Comcast Tower were too high for virtually any other Philadelphia company to sign on as a tenant, they were less than half of what Comcast would have paid for a comparable building in New York City (not to mention the higher wages they would have to pay its employees there).  Thus, it was a relatively inexpensive showcase for them.

Cira Center, built in 2005, was made possible because of the significant KOIZ tax benefits. Few, if any, of the tenants there would have paid the expensive rents for a West Philadelphia address without the corresponding tax savings.  The third newer building, Three Franklin Plaza, was built by Liberty Property Trust for Smith Kline who had outgrown its home at One Franklin Plaza and needed expansion space. While the University City Science Center has developed some new office buildings in West Philadelphia, the drivers for these projects are incubation platforms for emerging businesses, drawing on university talent and resources, as opposed to pure real estate plays. The new construction at the Navy Yard has been justified by tax benefits and single tenant headquarters buildings.

Why are no new Class A office buildings being built in Center City Philadelphia?  Because in order to justify the development costs for these new buildings (between $350/sf and $400/sf), landlords require “replacement cost” rents of between $32/sf NNN and $40/sf NNN (or $40-$48/sf gross).  As very few existing buildings in Center City are currently commanding rents in even the $30/sf gross range, it has been hard to find any tenants willing to pay a $10/sf to $18/sf premium for new construction of generic office space.

Because rents are ultimately driven by supply and demand, the only way for the rental market to rise to a level that justifies new construction is for either (1) supply to shrink and/or (2) demand (i.e., employment) to grow.  With practically no new construction over the past 22 years and several Class B office buildings like 1616 Walnut, 2040 Market and potentially 260 S Broad being repositioned as multi-family projects, physical inventory of office space is in fact shrinking.  This would normally put upward pressure on rents.  However, important emerging trends in corporate real estate space utilization have firms consuming less square footage per employee as: (1) the size of the enclosed office sizes continues to shrink; (2) office  space users are transitioned into smaller workstations in “open plan” environments; and (3) hoteling and telecommuting arrangements result in planning for less than 100% of actual headcount. These space utilization trends have the effect of decreasing overall demand for space even as the economy picks up and employment numbers rise.  Thus, for now, rental rates remain relatively flat.

The lack of rental growth in Center City over the past 20 years is evidenced by the fact that we are seeing lease proposals today for many buildings that are eerily similar to the proposals we saw in those same buildings 20 years ago.  Because gross rental rates have remained flat while building operating expenses and taxes have grown over time, landlords’ rental profits (i.e., NNN rents) are actually shrinking at alarming rates, especially on an inflation adjusted basis.  The shrinking NNN rents help explain why, to our knowledge, only two buildings in Center City have sold in the past 20 years for more than their replacement cost:  Comcast Tower and Verizon Tower (the latter was actually a sale leaseback financing transaction as opposed to a pure sale).  Both of these towers were sold shortly after the initial tenant(s) moved in. If NNN rents cannot grow beyond replacement cost rents, there is no possibility of building appreciation, especially given the historically low cap rate environment for commercial real estate over the past several years.

Walking through Center City, it is becoming painfully clear that our stock of Class A buildings is aging, and that new, state of the art office inventory is essential to keep Philadelphia competitive with other world class cities.  While there are clearly benefits to having low rental rates in Center City, unless they increase, we will see no new additions to our skyline any time soon.

For more information contact Glenn Blumenfeld

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