MARKET HIGHLIGHT, MAY 2006

BOSTON MARKET HIGHLIGHT

Boston Office Market

The Boston office market recorded more than 2 million square feet of positive net absorption during 2005, the market’s second highest year on record behind 2000. The pace of growth has exceeded expectations and brought availability down to 14.4 percent from 17.6 percent a year ago, a 3.5-year low.  Boston’s direct vacancy rate is at 10.7 percent, and is fast approaching single digits. 

The Class A market has tightened even more than the overall market to availability and vacancy rates of 13.9 percent and 8.9 percent, respectively.  At this time last year, there were 15 available contiguous blocks of space of more than 100,000 square feet in the Class A market, compared to only nine today.

Strong Demand

Despite sluggish job growth, leasing surged in 2005. The majority of this activity is coming from small to mid-sized firms seeking 25,000 square feet or less. We are witnessing competition for space in this range throughout the city’s mid- and low-rise office buildings. This size range continues to account for 80 percent of active requirements for space in the market. These tenants have become Boston’s bread and butter.

A few large tenants, however, such as Wellington Management Company and Bingham McCutchen LLP, arrived on the scene signing significant leases that included expansions. The financial services and law firm trends will continue, as Eaton Vance and WilmerHale are the two largest tenants actively seeking office space in the market. Corporate consolidations continued to impact the Boston office market as well, and could resurface with the outcome of Procter & Gamble’s acquisition of The Gillette Company yet to unfold. 

The South Boston Waterfront, a market that struggled during the downturn, is rebounding nicely. Institutional owners such as Archon Group and Berkeley Investments have purchased buildings here and are making a long-term commitment to the district’s future.

Asking Rents Climb — Is Development Around the Corner?

Boston’s average asking rent increased to $34.43 per square foot gross at year-end, a 6.2 percent increase from mid-year. This marks the first time the market has experienced back-to-back quarters of rent growth since 2000.

Asking rents in some of Boston’s premium towers reached $56 per square foot gross in 2005, and are expected to break the $60 per square foot barrier over the next 6 months. Rents in the Class B market have stabilized, averaging $26.14 per square foot gross, and are poised to increase in 2006 as options in the Class A market become less viable and competition increases.

With market conditions improving, some developers are hoping to start construction by end of 2006. The most likely office project to start is Equity Office Properties Trust’s mixed-use development at Russia Wharf, which will encompass approximately 500,000 square feet of office space with residential and retail components. The second office development that could commence by late 2006 is Fan Pier, a 21-acre land site permitted for nearly 3 million square feet of mixed-use development including 1.1 million square feet of office space. 

Expert Opinion

Boston’s money management, legal, and professional services industries will continue to fuel this recovery well into 2006. With few existing options for large tenants and musical chairs in Class A space becoming less viable, the prospect of sustained demand and continued tightening bodes well for potential new developments and well-located Class B product. However, further corporate consolidations could impede the recovery process.

— Benjamin Heller, vice president of Spaulding & Slye, a member of the Jones Lang LaSalle group.

Boston Investment Market

Coming off a strong year in 2005, the office market in Greater Boston has gained considerable momentum during the year. With a tightening in vacancies, many submarkets are finally seeing evidence of rent growth.  With a structural vacancy benchmark of 10 percent, we may see projects jump off the drawing boards into reality in the next 12 months, assuming absorption continues its recent pace. With current Class A average market rents of $40 per square foot in the CBD and $30 per square foot in the Route 128/MassPike suburban market, we would still need to see rent growth of 30 percent to 40 percent in order to justify new construction in those markets. However, new starts  are unlikely to move forward without a significant pre-lease requirement. With fewer available large contiguous blocks of space, many large space users are accelerating their space planning needs in order to take advantage of the tenant-favored market conditions. This activity has manifested in increased sales transactions.

The Boston CBD historically has been attractive to investors/lenders and has seen consistent low cap rates on purchases. Partially to completely vacant assets were also in high demand due to the condominium or hotel conversion potential. The re-zoning for residential on CBD assets has been received generally well by the city and the Boston Redevelopment Authority due to its desire to create more housing (market-rate and affordable) and strengthen the downtown’s 24/7 appeal.  In the suburbs, sellers are now realizing value not only for leases/income in place, but also are receiving credit for vacancy which in the recent past did not factor too much in a buyer’s price. Pension funds, foreign investors (especially Australian), and operators with opportunity fund capital have dominated the acquisition market.

There have been a few recent transactions worth noting, including Transwestern’s purchase of 40 Broad Street, a 300,000-square-foot Class B office building in the Financial District for $50 million from Prudential (formerly TMW). The asset was 35 percent leased at the time of purchase. Transwestern’s business plan is to retain the property’s office use and lease up the vacant space drafting off the strength in the Class A market. The purchase at $166 per square foot and projected all-in basis at stabilization, even if it costs $50 per square foot or more to re-tenant the building, will be well below replacement cost. If the asset were sold a year ago in the same condition, it would more than likely have been a residential conversion play. The buyer’s plan highlights the current softness in the condo market, as well as the rising office market conditions. Like other German investors, Prudential’s TMW (a fund made up of German insurance, private banks and individual investors) has been seeking increased liquidity in many of its real estate holdings since the Mills Corporation earnings re-statements.

Another noteworthy transaction was Broadway Partners’ $63 million purchase of 100-300 Fifth Avenue from TA Realty Associates, a 475,000-square-foot office portfolio comprising three buildings located in the prime suburban Route 128/MassPike office submarket. At $132 per square foot, without even considering the excess land that could support an additional 100,000-square-foot building, the buyer is at 60 percent of replacement cost on the asset which was 76 percent leased at the time of sale. Owners that have been sitting on assets for the past 3 to 5 years waiting for a market recovery are now inclined to sell their assets, as the prospects for growth haven’t looked so good in a while.

 The only caution signal might be the pace of absorption, which overall has outstripped job growth, hence tenants are growing faster than they are hiring. This shadow/expansion space currently represents about 8 million square feet of vacant space in the market or 5 percent of the entire supply. Overly aggressive business plans and tenant expansion were the primary reason we got hurt in the last downturn.

— Dennis Walsh is a senior director   in the Boston office of Tremont Realty Capital.

New England Retail Market

The retail sector in New England has been extremely active during the past 12 months. Construction volume is up, the region has witnessed several mergers and the economy continues to attract new investors. The primary driver for investment has been the imbalance of supply and demand. New England, a region that historically has comprised local retailers such as Lechmere, Caldor and Bradlees, is now a considered a major market for national chains such as Target, Kohl’s and Lowe’s Home Improvement Warehouse, among others. Why? While the economy may not be leading the nation in growth, it is supported by one of the most highly paid labor pools in the country.

One of the biggest retail stories in the region has been Federated Department Stores’ acquisition of The May Department Stores Company, the owner of the Filene’s brand. Federated, owner of competing brand Macy’s, is shedding all of the Filene’s stores it acquired in the merger, including the long-standing Boston store. Among new fashion retailers to the market are Barneys, which has opened a 45,000-square-foot store in the Copley Mall, and Nordstrom, which has started construction at the Natick Mall in Natick, Massachusetts. Swedish retailer IKEA has opened a store in Stoughton, Massachusetts, and has another planned for Assembly Square in Somerville, Massachusetts. Notably, Assembly Square is currently undergoing a three-phase, master-planned redevelopment, which will include a Christmas Tree Shops, T.J. Maxx and Staples, as well as mixed-use space containing 2 million square feet of office space, 1.3 million square feet of residential and 750,000 square feet of retail.

Capital markets transactions in 2005 include Heritage Realty Trust’s acquisition of Buckland Hills Parkade in Manchester, Connecticut, for $75 million, and Brookside Plaza, a supermarket-anchored shopping center in Enfield, Connecticut, purchased for $28.4 million by Equity One at a cap rate of 6.4 percent. The most high-profile recent urban retail sale has been Marketplace Center. Acquired by Anglo Irish Bank on behalf of private investors, Marketplace Center represents 51,000 square feet of high-end shopping in Boston’s Faneuil Hall and was purchased for $962 per square foot. Average cap rates for grocery-anchored retail transactions in the New England market declined 60 basis points in 2005 to 6.9 percent, while infill/urban deals such as Trader Joes’s Plaza in Needham, Massachusetts, and the aforementioned Marketplace Center are commanding cap rate premiums in the 5 percent range. Overall, yields on New England retail property are below the national average of 7.5 percent but are consistent with other 24-hour cities and remain favorable when compared to other property types.

— Rick Cleveland, Assistant Director of Research with the Boston office of Cushman & Wakefield.

Boston Multifamily Market

During the last 6 to 9 months, the apartment market in Boston has shown marked improvement. Property performances are solid and asset values are strong. Asking rents are up year-over-year in most markets, but are still below the strong 5 to 7 percent annual growth posted from 1999 to 2001. Concessions remain prevalent, however, particularly for new construction properties during the lease-up period. Sale activity continues at a brisk pace. Apartment investors from outside New England, attracted to Boston’s high barriers to development, are now showing even wider interest in the region. The 70-plus colleges and universities located in Massachusetts, a highly paid workforce and an average single-family housing cost of $414,000 in and around Boston give investors confidence that the pool of potential renters will continue to be strong. 

Existing Class A properties in 2005 traded at an average of $307,000 per unit. The average per unit sale price for the market was approximately $202,000 in 2005, with cap rates on A and B properties ranging from 4.5 to 6.5 percent. Recent sale transactions include Longview Place, a 348-unit Class A asset purchased by Equity Residential for more than $313,000 per unit; a 186-unit Class A property in Cambridge bought by Archstone-Smith at a cap rate of under 5 percent; and 295 units purchased by BlackRock Realty for an approximate 5.5 percent capitalization rate. The market has witnessed a number of transactions priced for conversion with cap rates on these going as low as the high 3 percent range. Most notably, 12 Stoneholm Apartments, a 1920’s Class B property in the Fenway that was rehabbed in the 1970s, was purchased for conversion at a cap rate of 3.8 percent. However, conversion activity has slowed in 2006 as more acquisitions are now being made for income versus quick capital appreciation.

Going forward, the lack of strong forecasted growth for the region is a concern. Although employment is predicted to accelerate in 2006, Moody’s| Economy.com notes that Massachusetts’ economic recovery has been one of the slowest in the nation. Another concern is outward migration. While it has only lost 19,000 residents since 2003, the state is concerned about its ability to retain younger residents. Nonetheless, Boston is a leading center for global industries, including biotechnology, healthcare, financial services and education. With its high cost of housing and a rising interest rate environment, along with a sustained industry base, the Boston apartment market should continue to perform well.

— Rick Cleveland, Assistant Director of Research with the Boston office of Cushman & Wakefield.

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