FEATURE ARTICLE, JUNE 2005

NORTHEAST OFFICE MARKET IMPROVING
Brokers in major markets are finding that the office sector is stabilizing.
Nicole Thompson

Northeast Real Estate Business talked to brokers in Philadelphia, New Jersey, Boston and New York City to get their take on the Northeast office market.

Jeff Algatt, regional manager in the Philadelphia office of Marcus & Millichap
Robert Bull, senior managing director in the Edison, New Jersey, office of Studley
Gil Dailey, senior director in the Boston office of Cushman & Wakefield
Peter Lindner, associate with New York City-based NAI DG Hart

NREB: How do you see the office market in the Northeast in general and in your market?

Algatt: It's improving in terms of sale prices, sale velocity, office leasing absorption and new construction. As a matter of fact, just recently in the Philadelphia marketplace, Liberty Property Trust started its first spec office building in the past 3 or 4 years. They're building a 110,000 square foot property up in central Bucks County. We haven't seen that for a long time. Philadelphia is an “old economy” business market, which fared very well during the last economic downturn. In Philadelphia, leases are on the move up, asking rents are inching up a little bit, we think about four-tenths of a percent this year, to about $22 a square foot, and effective rents are going to trend right along with that, rising to about $18.34 a square foot, which is a spread of roughly 15 percent. The owners are keeping a handle on concessions. We're projecting a decline in vacancy of about 40 basis points to 13.5 percent, and I think we're going to see more demand in suburban locations, particularly for medical office buildings.

Bull: The worst, I think is over. I think you’re seeing some transactions and a raise in net absorption in particular markets. And you’re seeing a move toward equilibrium, more so than in the past. The New Jersey waterfront is really like the sixth borough of New York. Most of the leases you find away from the waterfront have historically been five years; because tenants don’t really know how long they’re going to be in New Jersey, they don’t want to commit many more than five years. What I’m seeing a lot of in the last year or so, is to get the tenant improvements that tenants need to fund their build-outs, or to get an extra month or two free rent to defray some costs, terms are going longer. While tenants are still reluctant to do a 10-year transaction, or longer, you see a lot of deals now going from 5 to 7, 7.5 years.

Lindner: Specifically in New York City, it’s definitely a strong market. Vacancy levels have been trending down; asking rents have been rising steadily over the last two quarters. We predicted that financial service firms and law firms were going to feed the market going into 2005, and that’s played true with some of the major renewals and expansions in New York City. One major trend is financial service firms disposing of a great deal of space. Law firms have been acquiring a great deal of space. Instead of going out into the market looking for 200,000 square feet or greater they’re choosing to renew, and exercise expansion options. Driving those trends is the diminishing supply of quality Class A, contiguous office space.

Dailey: We’re starting to see some signs of light in Boston — we’re starting to see more traffic in the market, more competition for high-end space in high-rise Class A towers, which is the starting signs of recovery. We certainly have had some consolidations between Bank of America’s purchase of Fleet Bank and ManuLife’s purchase of John Hancock and, most recently, Proctor & Gamble’s purchase of Gillette. But, despite those consolidations, we still have had a healthy first quarter 2005 and are starting to see some promising signs.

NREB: Do you think growth will be affected by what looks to be rising interest rates over the next year or two?

Algatt: I think rising interest rates will have an affect on all investment real estate. I don't think it will affect the leasing side of it. I think, frankly, the reason we're going to see rising interest rates is because we'll be in an improving economy. And an  improving economy means more jobs and more corporate profit, which means more demand for office space, so I see a continued trend in positive absorption, lower vacancies, and a shrinking gap between effective rents and asking rents. The interest rates, though, will have some impact on values, because at some point, if rates rise high enough, cap rates will have to move, and we'll see a little lower valuation. But I don't think that's likely to happen for the next 12 to 18 months.

NREB: How are office investors finding growth in the current market?

Algatt: It's starting to come back. Office investors are finding opportunities to build. As I said, Liberty Property Trust is starting its spec building. Cira Centre is almost complete. Liberty has also started construction on the new Comcast Tower. Construction is going to be up by about 350,000 square feet this year.

Lindner: The investment sales market is still strong. With money still cheap and interest rates relatively low, there’s still more capital than there are office buildings for sale.

NREB: Have you seen any trends as far as types of office property?

Algatt: We're seeing some interesting sale-lease back opportunities with medical office buildings, where a medical practice will own its building, decide that they don't want to have their money tied up in real estate, so they'll sign a 10-year lease on the building, and then sell it to an investor. It's an effective and much more efficient way to raise capital, than a conventional mortgage. Because if you've got to finance a property, you can probably only get 60 to 70 percent on a refinance. If you do a sale-leaseback, you can get 100 percent of your value back by selling it.

NREB: Any significant developments?

Bull: The only place that I’m seeing actual dirt being moved and steel going up is in Princeton. There are two buildings that are under construction right now for the first time in 6 years. One of them is approximately 170,000 square feet and is being developed by the Patronelli Group. The other project is approximately 135,000 square feet, and is being developed by a local developer called Hilton Realty. I know that Brandywine Realty Trust is very close to breaking ground on a spec building of about 75,000 square feet in Lawrenceville. But other than that, you don’t really see anything. The reason it’s happening in Princeton is because, while the vacancy rates haven’t changed that much, there are very few blocks of large, contiguous Class A space. A vacancy number can be very misleading. You could have a vacancy of 20 percent in the market, and that 20 percent is all in 5,000- and 10,000-square-foot blocks of space . But if you’re a 50,000 square foot user, you can go into a 20 percent vacancy market and have virtually no opportunities to lease space. You could probably count on one hand the number of opportunities of 40,000 square feet and greater of Class A space. That’s what’s prompted a couple of these developers to take a risk and to come out of the ground with space. 

Lindner: 7 World Trade Center is a great example of what’s happening downtown. That’s a Silverstein property that was sadly destroyed in September 11 and rebuilt. It’s bringing 1.7 million square feet to market that will be available January 2006. When that’s introduced to the market, vacancy rates are going to fly up in downtown. Vacancies have certainly been higher downtown because there have been very large blocks of sublease available. But we’ve also seen downtown steadily stabilize  the last 3 years. So it’s a long haul, but I think downtown’s going to be all right.

NREB: Submarkets and corridors to keep an eye on?

Algatt: I'd say Burlington County, the Mt. Laurel area; Bucks County in the New Town area; Montgomery County in Blue Bell, Plymouth Meeting, Lower Gwynedd; Chester County in the Exton marketplace; Delaware County moving west past Chadd's Ford. There's some construction down in Newcastle County, just across the Pennsylvania border in an area called Naaman's Road/Silversid. And of course, the Comcast tower you see here in Center City.

Lindner: The Midtown South market is coming on very strong, with great buildings down on Park Avenue South and Fifth Avenue in the 100s. And downtown offers a great alternative to Midtown, with rents averaging approximately $32 per square foot, compared to Midtown, which is mid-$50s.

Dailey: We're seeing the most activity in the Financial District and the Back Bay, which are the two sort of primary markets.

NREB: Anything else of significance in the office market?

Algatt: In the past several years with the low interest rate environment, we’ve been seeing, on the investment side, the private sector investor being able to compete very effectively against the institutional investor because they are able to access significant low-interest capital, which used to be the bailiwick of the institutions, and they've been very aggressive and in many cases, beating out the institutions for larger and larger properties where there wasn’t competition before. As interest rates change, as underwriting criteria get more difficult, will the private sector still be able to compete with and outbid the institutions? That's the question. I would say yes, unless the institutions begin to get more aggressive, frankly since they've been losing some deals, I would expect to see them be more aggressive.

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