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MARKET HIGHLIGHT, SEPTEMBER 2004
PHILADELPHIA EMPLOYS ADAPTABILITY
TO CONTINUE GROWTH
During the first 6 months of 2004, Philadelphia’s commercial
real estate market has shown what flexibility and determination
can achieve by overcoming recent economic bumps and forging
ahead. The office market has shown nominal improvement so
far, and once the economy levels off, will continue to recover
in 2005. The investment market has remained active, with the
low interest rates and uncertainty surrounding other capital
markets driving activity. Also, during the past several months,
multifamily development in and around Philadelphia has markedly
improved, thanks to vacancy rates well below national averages.
The industrial market has stood strong, benefiting from zoning
ordinances and old-fashioned ingenuity.
Office
The region’s office markets showed nominal improvement
during the first 6 months of 2004. This will be a gradual
recovery rather than a rapid bust-to-boom cycle. Conditions
varied by submarket; the Pennsylvania suburban, Lehigh Valley
and Delaware office markets improved, while southern New Jersey
experienced a temporary increase in vacancy. Demand is still
weak; but the supply of space coming onto the market has leveled
off in most areas. So while absorption is minimal, vacancy
rates have not increased in most area submarkets.
For the first time in more than a decade, there is more space
under construction or pending in downtown Philadelphia than
in the suburban markets. These projects have been the source
of much debate regarding the awarding of tax-abated Keystone
Opportunity Zone (KOZ) status to the new sites. Cira Center,
being developed by Brandywine Realty Trust, is a 727,725-square-foot
Cesar Pelli-designed office building. The project is adjacent
to Amtrak’s 30th Street Station, at the bridge between
the traditional central business district (CBD) and University
City, and was awarded tax-free enterprise zone status. This
tax abatement represents significant savings to possible tenants
based on job creation. Two large law firms, currently located
within the CBD, are the lead tenants signed to Cira Center.
Liberty Property Trust, the developer of the proposed One
Pennsylvania Plaza, has also been seeking tax-abated status
for the 1.3 million-square-foot building in order to help
secure the intended anchor tenant. Owners of existing Center
City buildings have vigorously opposed tax-free status because
it puts their buildings at a disadvantage. Proponents of granting
tax abatements feel it is a necessary policy to keep large
tenants in the city of Philadelphia.
In addition to the new projects, several of the CBD’s
largest tenants recently renewed or signed new leases for
significantly less space. The full impact of this decrease
in occupancy combined with new construction will not be felt
until later in 2005 and 2006, with the vacancy rate increasing
from the current 13.2 percent into the mid to high teens.
While the trophy and upper-tier Class A buildings will be
initially impacted, older Class A and B buildings will eventually
suffer the windfall as tenants “trade-up” to better
buildings.
During the last downturn in the market in the early to mid-1990s,
owners considered mothballing vacant buildings. Many of these
ended up being converted to other uses such as apartments,
student housing and hotels. As the job market recovered, the
CBD market was able to recover more quickly because there
were ultimately less office buildings. Considering the strong
residential market and continued demand to own rather than
lease, some owners may convert Class B and C buildings into
office condominiums or into a combination of low-floor office
and high-floor residential condo units.
New construction has leveled off in the Pennsylvania suburbs
of Philadelphia, giving the market time to absorb a significant
supply of space — the vacancy rate at mid-year 2004 was
20.1 percent. In southern New Jersey, particularly Burlington
County, new development has increased, but on a smaller scale.
Opus Corporation, Brandywine Realty Trust and Liberty Property
Trust have recently all been active.
The office market historically lags behind a general economic
recovery by 12 months to 18 months. Companies that are hiring
will reconfigure existing office space and fill underutilized
space before expanding. Therefore, while we foresee a gradual
decrease in the suburban vacancy rates during the next 6 months,
there will not be significant improvement until well into
2005. The CBD is likely to have an upward trend in vacancy
through 2006.
Asking rates are predicted to remain flat in the suburban
markets. However, in the CBD, landlords are likely to start
pre-emptively lowering rental rates in order to secure tenants
before the large blocks of space hit the market during the
next year.
— Gregory J. West, Executive Vice President, Colliers
Lanard & Axilbund
Multifamily
Philadelphia has lagged behind the rest of the country in
multifamily construction during the last decade; however,
new construction permits soared during 2003 as low vacancies,
positive rental growth, the specter of higher mortgage rates
and a decreasing supply of residential land provided the incentive
for developers to start new projects. In addition, the Philadelphia
area has had strong foreign immigration during the last 5
years, averaging more than 15,000 new residents annually,
despite post-9/11 limitations.
The CBD currently has the highest level of new construction,
with several luxury developments, both new and renovated underway.
The most visible development is the 47-story St. James tower
on Washington Square. Projects in the suburban markets will
be highlighted by several conversion projects such as the
Victor in Camden or new buildings in infill locations such
as Millennium in Conshohocken.
The overall Philadelphia metropolitan statistical area vacancy
rate is in the 4 percent to 5 percent range. Despite the trend
toward owning, rental demand has remained strong, and Philadelphia
is below the national vacancy rate, which is approaching 7
percent. The vacancy rate is likely to increase during the
next 6 to 9 months with the delivery of new units.
Both the volume of transactions and new offerings are down
year-to-date in 2004, reflecting the lack of properties on
the market. Cap rates have decreased steadily over the last
three years. However with an increase in the 10-year Treasury
Notes and the impending interest rate hikes, cap rates are
expected to increase shortly. Industry analysts currently
have varying views on the impact of higher interest rates
on cap rates and sale prices. Some experts feel that a rise
in interest rates will drive capital to other investment markets,
and cap rates will increase. Others believe that there is
enough pent-up demand for real estate investments that an
interest rate hike will not immediately impact cap rates.
Even if rates do rise, improving market fundamentals may offset
the impact of higher cap rates on value for multifamily investors.
Higher mortgage rates may benefit the rental market, resulting
in higher occupancy and eventually rental increases.
— Cary S. Tye, Esquire, Senior Vice President; Joel
Flachs, Vice President; Mitchell Gold, Senior Associate, of
Colliers Lanard & Axilbund
Industrial
The Philadelphia industrial real estate market has seen the
effects of two powerful forces: the Keystone Opportunity Zone
(KOZ) and adaptive reuse. The KOZ, which is administered by
the Philadelphia Industrial Development Corporation (PIDC),
has had its greatest effect to date in the Eastwick section
of the city. Adaptive reuse of older industrial buildings
has produced the beginnings of what has become a remarkable
transformation of several Philadelphia neighborhoods.
The advantage of the KOZ to the Eastwick section is simply
another addition to the natural benefits of the location.
Close to the Philadelphia International Airport, Interstates
76 and 95, as well as area bridges to New Jersey, the area
has long been an attractive target for industries needing
to be in this region. The high cost of construction was, most
likely, the most important factor holding down new construction.
Now, several new projects have begun, or are about to begin.
Construction of a 90,000-square-foot facility is underway
for DHL/Airborne, which will include significant expansion
capability. A build-to-suit project for the Brinks Company
will add another 50,000-square-foot building to the area.
Also, a 90,000-square-foot speculative project is to be divided
into units as small as 8,000 square feet and sold as condominiums.
The latter project is significant because there has been little
speculative industrial construction activity anywhere in the
Philadelphia region for several years.
Not far from the Eastwick section, the city and the state
did everything it had to do to retain the Produce Market.
The new market, approximately 900,000 square feet, will be
built in south Philadelphia at the foot of the Walt Whitman
Bridge.
While the build-to-suit activity continues, the sale of existing
industrial properties keeps pace as well. The historically
low interest rates have inspired entrepreneurs to purchase
the manufacturing and distribution properties they occupy.
In south Philadelphia, conversion of old factory lofts to
residential apartments and condominiums has been successful
for some years. Now, that phenomenon has spread to the area
north of Market Street, and along portions of the Interstate
95 corridor. Old buildings, once predominantly occupied by
the needle trade, are now prime for conversion to exclusive
residential use.
— Philip Rothenberg, Broker/Vice President, NAI
Mertz Corporation
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Philadelphia’s Investment Market
SHOWS STRENGTH
The regional investment market continues to be active,
driven primarily by historically low interest rates,
the continuing uncertainty of other capital markets
and 1031 tax-deferred exchanges. Sales in most markets
are limited only by lack of product. The office market
also is limited by weak fundamentals. Institutional
sales continue to lag due to lack of product to replace
existing yields and the still significant difference
between buy and ask. Credit remains the strongest element
in institutional and quasi-institutional due diligence.
Overall, the picture remains nearly the same as it has
been for the last 2 years, lots of capital carefully
pursuing every available deal. The only difference is
that 1031’s are less sensitive to yields due to
tax savings.
Multifamily — Investor demand continues to exceed
the supply of offerings. Cap rates range between 7.5
percent and 8.5 percent for Class A product and, despite
the softness on rentals and continuing increases in
operating costs, Class B product is not far behind.
Sale prices per unit have hit all-time highs for Class
A apartments with trades exceeding $140,000 per unit.
Class B apartment properties are trading as high as
$60,000 to $80,000 per unit. The low cost of capital
will continue to fuel low cap rates and subsequently
higher prices per unit.
Industrial — Sales volume was limited by a lack
of institutional grade product during the first 6 months
of 2004. The average sale price was $51 per square foot.
Two Class A distribution buildings in Southern New Jersey,
which were acquired in 2001, sold for an average of
$53, an increase of 40 percent in 3 years.
Net-leased industrial continues to be the darling of
the industry with long-term credit leases trading between
7.5 and 8.5 percent cap rates. Multi-tenant projects
are also being purchased by non-institutional players
at cap rates 50 to 100 basis point higher.
Office — Office remains the weakest sector of investment
activity. However, the outlook is improving because
of decreasing vacancy rates. The volume of sales is
down from 2003, as many institutional sellers are holding
property off the market due to high vacancy. However,
despite the 20 percent suburban market vacancy rate,
selling prices for the first 6 months of the year averaged
over $162 per square foot, with one well-located building
going for $266 per square foot. The average sale price
in the CBD was $106 per square foot and there is at
least one major sale pending. Equity Office has announced
that it would be divesting its Philadelphia-area assets,
which will likely generate a great deal of interest
from investors.
The value of product made available has been negatively
affected by continued vacancy and by difficult tenant-credit
problems. Long-term net leases are the exception, with
all available product being aggressively purchased.
Cap rates for well-occupied buildings with reasonable
credit tenants range from 9 to 9.5 percent.
Retail — The most competitive investment sector
is well-anchored retail. Sale prices for fully leased,
institutional grade neighborhood centers have averaged
approximately $165 per square foot, while the prices
for power centers have averaged approximately $170 per
square foot. Cap rates have generally ranged between
7.75 percent and 8.0 percent. Credit single-tenant retail
is the most sought after product type.
— Cary S. Tye, Esquire, Senior Vice President;
Joel Flachs, Vice President; Mitchell Gold, Senior Associate,
of Colliers Lanard & Axilbund
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