In a Class of Their Own
Class B and C Office Space Adapts to Changing Expectations.
The class B and C office market should be reaping the benefits of today's uncertain economy, as tenants flee class A properties in search of lower rents. However, first-quarter 2001 statistics suggest otherwise. According to Torto Wheaton Research, demand for class B and C office space declined far more than demand for class A space in markets that experienced the highest drop in overall office space demand, including San Francisco, Seattle, and Austin, Texas. Conversely, only two markets, Washington, D.C., and Boston, have seen class A demand drop at the same level or more than class B and C.
The current economy bestows both a blessing and a curse on the national class B and C office market. “Tenants are more apt to lease class B or C space in order to keep costs down,” explains Scott Brenner, CCIM, president of Zenith Realty Investments in Deerfield Beach, Fla.
However, many class B and C properties can't offer the open floor plates and technological amenities that many of today's tenants desire; therefore, these properties lose potential lessees to newer office spaces. In addition, class B and C rents also have risen in the past few years.
Due to these economic fluctuations and structural obsolescence, class B and C office properties have been forced to adapt in recent years. The future of individual properties depends on location and the current need for low-cost office space.
Often lumped together under the category of “other classes,” class B and class C denote distinctly different types of properties, yet consensus on the definition of each class often is difficult to find.
Cushman & Wakefield, for example, classifies buildings by age. Class B properties are those built between 1940 and 1960, and class C properties were constructed before World War II, according to David Duble, associate director of Cushman & Wakefield of California in San Francisco.
On the other hand, in its glossary, Grubb & Ellis/Krombach Partners in St. Louis defines class B and C properties by the types of users who lease them: Tenants seeking average rates lease in class B properties and those seeking below-average rates lease in class C properties.
Adding to the confusion, class definitions are highly subjective. “Any broker you talk to would probably have a different definition of how they determine class A and class B buildings,” says Michael Arnold, a senior associate at CB Richard Ellis in Los Angeles. Many commercial real estate professionals also add variables such as B+ and B- to make the situation even more complex.
Characterizations also depend on area. “There is some space in tertiary markets that will always be considered class C because of the location, regardless of what improvements are made,” Brenner says.
Due to the lack of strict definitions, comparison of buildings based solely on class is unreliable. Yet the class hierarchy provides a useful tool for commercial real estate professionals to determine what space best fits their clients' needs.
Although demand for class B and C office space is lower than previous years, most U.S. markets are still viable.
Nationally, demand for class B and C space fell 0.6 percent between year-end 2000 and first-quarter 2001, but this drop mirrors the decline of class A demand, suggesting that “building quality cannot fully shield a building's revenue stream from declines in the market,” according to About Real Estate , a Torto Wheaton Research column.
New York City's office market continues to be tight, and although B and C properties don't enjoy the nearly 100 percent occupancy rate and high lease rates of class A space, these buildings are far from empty. Vacancy rates for class B and C space in the New York metropolitan area average 8.2 percent, according to CoStar Group.
In New York, many trophy buildings reach class AA standards, which diminishes the fine line between class A and class B+ space, according to Ken Rapp, senior vice president of CB Richard Ellis. Most class B and C properties in New York are located in Lower Manhattan, he says, and classification mainly is based on geography, age, and interior floor space. However, demand for class B and C properties does exist, as many tenants are willing to go without amenities or a fancy address to pay lower rent, Rapp says.
Conversely, the class B and C office market in Philadelphia “for all intents and purposes is nonexistent,” reports Ed Piscopo, marketing services director of Trammell Crow. Class B properties are the “leftovers” from the class A market, and the few class C buildings in the city were converted into telecommunications hotels. In the 1990s, a majority of the class B office properties were redeveloped into residential or hospitality properties to serve the city's expanding convention center and its hosting of the Democratic National Convention in 1999. Class B lease rates in the central business district were approximately $19 per square foot at the end of first-quarter 2001; lease rates in suburban Philadelphia reach as high as $25 psf, according to Trammell Crow.
In metropolitan Chicago, the total inventory of class B and C office space comprises 181.5 million square feet, according to CoStar Group. Vacancy rates rose slightly to 14.1 percent at the end of May 2001, up from 12.7 percent one year earlier. Lease rates, on the other hand, have jumped almost $3 in the past year, now averaging $16.75 psf.
In suburban Chicago, class B space occupies 37 percent of the office market, with class C controlling 19 percent, according to Michael Whisler, CCIM, vice president of CB Richard Ellis in Lincolnshire, Ill. Lease rates range from $20 psf to $24 psf for class B space and from $16 psf to $19.50 psf for class C space. Sales prices range from $105 psf to $120 psf for class B space and from $70 psf to $95 psf for class C space, Whisler says.
In Minneapolis, demand for class B office space is high, says Jill Rasmussen, CCIM, a senior associate at Northco Real Estate Services. Yet most class C properties in this city are not attractive options, as they are characterized by obsolete floor plates, minimal amenities, and little telecommunications access. Lease rates for class B space range from $12 psf to $13 psf net, and class C rates run between $9 psf and $10 psf net. Sales prices vary significantly due to the wide variety of product type available, ranging from $65 psf to $115 psf for class B space and from $40 psf to $75 psf for class C space, Rasmussen says.
In southern Florida, class B office properties generally are small buildings with few tenant amenities, no covered parking and on-site security, and less-expensive common-area finishes, Brenner explains. Sales prices for class B space range from $70 psf to $125 psf, depending on quality of location and improvements, and class C prices average $60 psf to $90 psf, he says.
Despite south Florida's strong economy, “Class A space, particularly new space, has become prohibitively expensive for many of the smaller entrepreneurial tenants that dominate the market,” Brenner says. Since lease rates and operating expenses typically are lower in class B and C buildings, these properties are in great demand.
In Atlanta, class B and C properties occupy about 45 percent of the office market, and demand is strong, says Bill Adams, CCIM, president of W.T. Adams & Co. Realtors. In 2000, 1.6 million sf of class B office space was absorbed, yet only 45,000 sf of class C space was absorbed in the same year due to the large amount of sublease space on the market. Today, sales prices range from $70 psf to $80 psf for class B space and from $40 psf to $60 psf for class C space, he says.
The effects of the dot-com demise are felt strongly in San Francisco, where vacancy rates for class B and C space have climbed to 8.5 percent as of May 2001, up from 4.1 percent 12 months prior, according to CoStar Group. Meanwhile, lease rates keep rising, to $39.21 psf from $34.33 psf.
The high vacancy rate in the Los Angeles metropolitan area has fluctuated little in the past 12 months and rests at 11.5 percent as of May 2001, up from 10.8 percent one year earlier, according to CoStar Group. Net absorption is negative 216,564 sf.
A lack of new construction is good for Los Angeles because the market isn't plagued with an abundant oversupply of space, Arnold says. Class B and C properties are in demand, especially by small users that are willing to exchange lower rent for fewer amenities and by entertainment and high-tech companies that don't want to lease in more corporate-oriented high rises. In Los Angeles, class B and C offices have a different look and feel than class A, which attracts tenants seeking a more-relaxed environment, Arnold says.
Making the Grade
Some property owners are renovating their class B and C office buildings into class A properties to lure high-rent tenants.
Downtown Chicago has experienced a building boom in the past few years, with many new class A properties scheduled to enter the market soon. To compete, many older buildings are being renovated completely. For example, the former Insurance Exchange building at 175 W. Jackson, a class C building designed by Daniel Burnham, recently was turned into a class A property. Before the rehabilitation, the 90-year-old building was only 20 percent occupied, according to Menahem Deitcher, director of leasing for the building.
After an $80 million interior gut rehabilitation, 175 W. Jackson now offers 24-hour security, 40 new passenger elevators, underground parking, a state-of-the-art telecommunications system, and a new heating, ventilation, and air conditioning system. The building is 75 percent leased, and Deitcher expects little difficulty leasing the remaining space.
In Atlanta, after the 1996 Summer Olympic Games, many class B and C office properties were renovated to take advantage of the drawing power of the Centennial Olympic Park and the extensive fiber-optic grids installed to broadcast the games. One such property was 101 Marietta, a class C building primarily occupied by the federal government, Adams says. Located across from Centennial Olympic Park, the 637,000-sf building underwent a complete rehabilitation, including the installation of new elevators and mechanical and electrical systems, a new exterior streetscape, and marble finishes. The total cost was $35.4 million, and today it is 95 percent leased.
B Isn't So Bad
Upgrading from class B or C to class A in New York is extremely difficult, because most of the older buildings don't have enough open floor space to compete with new construction, Rapp says. Therefore, many class B and C buildings are rehabbed into class B+. For example, the former Bank of New York Building at 48 Wall St., built in 1927, recently underwent a $30 million gut rehabilitation, which included the addition of a new lobby, elevators, and a HVAC system; however, since the interior columns couldn't be removed, the building is now classified as a strong B+ instead of an A, Rapp says.
In a $53 million renovation, the Chrysler East Building at 666 Third Ave. in New York was transformed from an undistinguished 32-story, side-core structure into a 710,000-sf, center-core office tower with an elegant dark-gray curtain-wall glass façade. However, since it was built in 1951 and depends on interior columns for structural strength, it only jumped to a class B+ rating, according to Rapp.
In the Houston office market, “Many owners and/or tenants may look down on class B or class C space, but it does serve a definite purpose ... and can be financially rewarding,” reports James W. Sinclair Jr., CCIM, CPM, a property manager with Transwestern Commercial Services.
For example, three years ago, the Esperson Buildings in downtown Houston was a two-building, class C property. Of the property's 595,000 sf, only 60 percent was leased by 48 tenants, Sinclair says. Since then, the ownership has poured approximately $15 million into infrastructure and cosmetic improvements that have raised the class of the building to “a strong B+, perhaps an A- level,” and the total space leased has jumped to 78 percent, Sinclair says.
As the frenzy to renovate class B and C office properties gains strength, this market faces mixed predictions for its short-term future.
Downtown Chicago is peppered with older buildings in similar situations to 175 W. Jackson, and there is “no question about it” that these properties must be completely renovated to remain economically viable, Deitcher says. Whisler foresees that lease rates for class B and C office space in suburban Chicago will remain flat or decrease.
Minneapolis' class B and C office market will fall victim to new technology-ready buildings with large floor plates, Rasmussen predicts. She expects many new subleases to hit the market in the near future due to increased downsizing.
In southern Florida, landlords are forced to offer more concessions to tenants due to perceptions of an economic downturn that are causing tenants to make slower leasing decisions, Brenner says. As available land runs out, “more and more class B and C buildings will be renovated and repositioned.”
Atlanta is experiencing an oversupply of class C office space due to high-tech companies that have downsized or gone out of business, Adams reports. He predicts that lease rates and sales prices will fall and new construction will slow.