News

Why Rising Rents are Not Necessarily Bad For Tenants

Tactix

As pure tenant only brokers, we like soft real estate markets where supply outstrips demand. Generally speaking, in these types of markets, tenants hold the upper hand and can exert their leverage to secure aggressive lease deals.  While it is certainly nice to be able to take advantage of weak market conditions, a sustained down market is not healthy for the region or for tenants in the long term.

Philadelphia and the surrounding suburbs have suffered from a relatively flat rental market over the past 20 years. Because supply has generally outstripped demand, rents have not grown over time.   As the cost of constructing new buildings has increased over time (even in a relatively low inflation environment), landlords need higher rental rates to justify the higher costs of new buildings.  Unless and until  “market” rental rates for existing buildings reach “replacement cost” rents (i.e., the level that a developer needs to obtain to justify the investment in new buildings), developers will not start new projects. Thus, there have been very few speculative commercial office building projects in our region outside of the Keystone Opportunity Zones (which have both State and local tax incentives which help offset the higher rental costs).

Assume for example that a suburban office building costs $300/sf to build.  Further assume that, in order for the landlord to achieve his required hurdle rate of return for this investment,  he needs to achieve a 9% lease constant (the factor, applied to the cost, that results in the required rate of return after taking account of the landlord’s cost of capital and applicable amortization periods). This would require a NNN rent of $27/sf (i.e., $300/sf x .09). Adding operating expenses and taxes (assuming there is no tax abatement for new construction) of, let’s say, $8.50/sf would yield a “replacement cost” starting gross rent of $35.50/sf.  If and to the extent rents for existing Class A buildings in the surrounding areas are $29/sf, it may be hard for a tenant to justify paying a $6.50/sf premium for a new building unless it had unique requirements that could not be accommodated in the existing building inventory.  If, however, market rents for existing Class A buildings in the area approached $35/sf gross, developers would be able to justify the investment of new dollars and tenants could justify paying a small premium for a newer product.

In Center City and the surrounding suburbs, market rents have not reached replacement cost and, as a result, very few speculative buildings have gone up in the past 10 years.  Instead, developers have bought Class B buildings at bargain prices and converted them into Class A and A minus buildings at a fraction of the cost of new buildings (examples of these include One Presidential Blvd in Bala Cynwyd and several projects along Swedesford Road and Warner Road in Wayne).  With the lower cost basis, landlords don’t need to obtain replacement cost rents to justify their capital investments and, therefore, they can effectively compete in the market with their repositioned asset.

Certainly tenants have benefitted from soft market conditions over the past 10 to 20 years. However, as we take a look at our existing building stock, we have paid a price for this tenant friendly environment.  Our building stock is aging.  In Center City, the average age of our building stock is over 50 years old. Not only are these buildings old, they are also energy inefficient.  The bright and shiny buildings that changed our stagnant skyline in the late 1980s and early 1990s have lost some of their luster.  Likewise, Conshohocken, which sprung from brownfields in the 1980s and 90s has seen little change since.  Some hope is on the way with the announcement of FMC Tower at Cira Center South and the new Comcast Center Tower.  University City is abuzz with new projects as is the Navy Yard.   Market rates in Radnor are hovering around replacement cost which may allow some new development in and around that submarket.  Don Pulver is peddling a new Seven Tower Bridge and Keystone is trying to move forward with a new, 200,000sf mixed use development in Conshohocken.  However, we need more and we need these new assets in our core markets including Center City.  If we are truly to become a world class region, we need to upgrade our building stock and continue to redefine our skylines.  Businesses don’t operate the way they did 30 years ago so we need new buildings with designs and features that support our new operational paradigms.  We also need to improve our carbon footprint with more environmentally responsible buildings.

While it may seem anathema to our founding principles for Tactix to be extolling the virtues of rising rental rates, there is a method to our madness. Philadelphia, the surrounding suburbs and Wilmington are still extremely low cost real estate markets relative to other large, metropolitan areas.  High quality assets in the Delaware Valley can be leased in the mid $20s to mid $30s/sf which is less than half of what it costs in Washington, D.C., Boston, San Francisco and Chicago and about one quarter or less of what it costs in New York City.  We also need to consider the long term.  Our office inventory is shrinking as older, more obsolete buildings have been repurposed as apartments, charter schools and other uses.  By constructing new buildings, inventory will increase thereby creating more choices for tenants and, ultimately, more vacancy (unless our region finds a way to grow employment proportionately).  Over the long term, tenants will get better deals in better quality assets if we replenish our building stock now.

For more information contact Glenn Blumenfeld

Get in Touch

I’d like to learn more about Tactix