Office

New Office Order

Technology Is Changing the Tenant Base and Expectations for Office Properties.

The nation's 30 billion-square-foot office market is in sound health as it heads into the second half of 2000, but it slowly is taking on a new look. Consider these surfacing trends:

  • Newly created Internet companies are gobbling up space at a feverish pace in some markets.
  • Construction of low- to midrise “smart” office buildings are helping second-tier cities compete more effectively with their bigger rivals.
  • A resurgence of first-tier markets is making developable land at reasonable prices harder to find in many large cities.

Nationally, the battle of the suburbs vs. the city rages on, with spacious campuslike structures competing against the lure of 24-hour cities' services and entertainment. And in a fistful of first- and second-tier markets the suburbs are winning, marking a change from last year's hot central business district market. (See “CBDs Sizzle,” CIRE, July/August 1999.)

Eight suburban markets each show more than 3 million sf under construction, accounting for 45 percent of all new North American office construction today, according to a report from Oncor International companies in 41 non-CBD markets.

In addition, a number of first- and second-tier markets show little new construction activity downtown, but plenty going on outside the CBD, according to Oncor's report. These cities include Los Angeles, with 3 million sf of new non-CBD space going up; Dallas-Fort Worth, building 3 million sf in the suburbs; the northern New Jersey market constructing 4.5 million sf outside CBDs; and Philadelphia, building 1.5 million sf of suburban space.

Enter the Dot-Coms
Like other property segments today, office is at the crossroads of technological change. Outwardly buildings look more casual; but inside systems — electrical, data transmission, and heating, ventilation, and air conditioning — must meet rigorous high standards.

High-tech companies involved in telecommunications, Internet services, and media production are leading the way as today's new tenants in markets across the country.

Despite their wild ride on Wall Street, burgeoning Internet companies are devouring new and existing space in numerous markets. For instance, as new dot-com tenants entered the 29 million-sf Seattle market, year-end 1999 vacancies dropped to 2.1 percent from 4.2 percent in 1998 and 5 percent in 1997. Class A vacancies are down to 1.5 percent and class B space is 4.3 percent vacant.

About 3 million sf of new CBD construction is on the drawing board for 2000 — with technology tenants already reserving 60 percent of that volume. The 16.6 million-sf Seattle CBD has a vacancy level of only 2.3 percent. Eastside, Seattle's largest non-CBD market with 20.9 million sf, has 3.8 million sf of new space under construction.

“Who is behind this madness?” asks Nathan Brown, an information management researcher at CB Richard Ellis in Seattle. “Why the dot-coms, of course, otherwise known as the ‘I need 2,000 sf now and 50,000 sf next week' crowd. A more balanced market may not emerge until late 2001, at the earliest,” Brown estimates, “when some of the … proposed space begins to materialize. Only a widespread collapse of the Internet firms would loosen up the market any sooner.”

Several Texas cities also are experiencing the Internet explosion firsthand. “We've been seeing many dot-com companies making a dash to CBDs in Dallas, Fort Worth, Houston, and Austin,” says Jerry Fults, CCIM, executive managing director of Kennedy-Wilson International's Dallas division. “These companies need to be near fiber [optic] loops to be effective — loops that are typically found near and in downtown areas,” he says. “The dot-coms and young technology businesses will put up with almost anything — like old buildings, cramped quarters, and poor parking — to get to that bandwidth.”

In some markets, accommodating technology-oriented tenants has become the No. 1 goal of developers involved in both new office construction and retrofitting older structures. Many high-tech companies are looking for new space that echoes the casualness and openness of rehabbed industrial lofts. The result is a nationwide surge of low- to midrise buildings with open floor plans, high ceilings, and exposed infrastructure, jampacked with high-tech bells and whistles, according to The Wall Street Journal .

This design is popular with second-tier cities that are not hemmed in by a lack of developable land. The smaller markets also tend to be less congested, offering shorter commute times, another important plus.

The Ninigret XI, a 94,000-sf, four-story smart office building minutes from both Salt Lake City and the Salt Lake City International Airport typifies this trend. The structure offers 25,000-sf floor plates; a below-floor HVAC system that allows tenants to control airflow for every usable 100 sf of office space; an additional below-floor electrical and data distribution system; and an indirect lighting system set up at ceiling heights ranging from 9 feet to 16 feet on various floors. Developer Randy Abood is absorbing the cost of the high-tech construction features; none of the special items will be charged against any tenant improvement allowances.

Another smart building under construction is the six-story, 250,000-sf, $40 million Stadium Gateway in Anaheim, Calif., scheduled to open in second-quarter 2001. The project's timing couldn't be better or the site more strategically located, according to Jack Mahoney, president of El Segundo, Calif.-based Summit Commercial Properties, the joint developer with Mack-Cali Realty.

A $1.1 billion state-funded transportation improvement program will double the width of Interstate 5 through a 10-mile stretch near the office project, and a new carpool lane will route traffic directly from the freeway to the office site. In addition, both the nearby Anaheim Convention Center and Disneyland are undergoing renovation and expansion.

Besides location, the project features H-shaped, 42,000-sf floor plates and “extremely competitive monthly rental rates — $2.15 [per sf] to $2.30 psf full service — which already are attracting significant interest from some very progressive companies,” Mahoney says. Additionally, the monthly rent includes four parking garage spots per 1,000 sf leased and free surface parking.

In Tulsa, Okla., large floor plates helped convince U.S. Cellular to sign a long-term, ground-floor lease for 67,000 sf of contiguous space at Union Pines, a planned three-building, 300,000-sf, $33 million office park that Trammell Crow Co. is developing. The venture is Tulsa's first completely speculative office project in more than 13 years.

“Tulsa is back in new construction,” says George Thomas, CCIM, a broker at Whiteside and Grant Realtors in Tulsa, who helped clinch the U.S. Cellular lease. “We were known for so long only as the Energy City, taking it on the chin so far as new construction went. But that's beginning to change. The cranes are back in the air.”

24/7, But Nowhere to Build
As the second-tier markets try to compete with the rebirth of the major 24-hour cities, some first-tier markets are experiencing the downside of good times: no space to build. As developable land at cost-effective prices continues to be scarce, developers counter by constructing taller towers on smaller pads.

That's what is happening in Manhattan, the nation's largest office market. “The constraints of land scarcity [continue to] demand high-rise development in Manhattan, [while] in the suburbs, the limited development activity is traditional suburban midrise,” says Craig Evans, CCIM, senior director at Cushman Realty in New York.

While Evans believes the bulk of the demand for new office space in his market will continue to be in Manhattan, he concedes, “Sharply increased rental rates in prime Manhattan areas are pushing tenants to frontier locations within the city, primarily toward the West Side.”

In other markets, demolishing older CBD structures is providing the needed dirt. “I don't think we have run out of developable land yet,” notes Michael McNamara, head of acquisitions for Lend Lease Real Estate Investments in Atlanta. “In many instances, changes of use in the existing structure will provide available land on which to build.”

Evans agrees that except for New York, Boston, and San Francisco, most first-tier cities still offer some potential downtown developable sites. Boston, particularly, is “supply constrained and politically constrained,” Evans says.

In some markets the scarcity of developable land is not limited to just the CBD, and the result will be more than just taller buildings. In San Diego County, for example, David B. Marino, executive vice president of the Irving Hughes Group/CRESA, a corporate tenant-representation company, says he expects land scarcity to lead to only one obvious conclusion — a landlord's market.

“This building and land constraint in the most central and desirable submarkets in the county will cause significant rent inflation during 2000 and 2001 if the economy holds its growth pace,” Marino says. “We are likely to see landlords demanding — and getting — longer lease terms and rental rates with high rent increases and lower tenant improvement allowances attached to them.”

Current CBD rents in the 50 million-sf San Diego office market are in the $20 psf to $28 psf range vs. $18 psf to $25 psf in 1999. Suburban rents are $20 psf to $33 psf.

Another trend, high-credit-risk telecommunications companies devouring class B and C space in a number of major markets, has triggered innovative rent paying strategies including letters of credit guaranteeing a year's rent for security and stock options.

Second Tiers Blossoming
A sampling of second-tier markets from around the country shows strong fundamentals, a good balance between supply and demand, and a slight upturn in rents. Speculative development remains low, despite strong occupancy figures.

In Orlando, Fla., office sales activity remains strong. But Ronald J. Rogg, CCIM, an investment properties senior associate at CB Richard Ellis, doesn't expect a repeat banner year in 2000 because of the large volume of sales activity over the past two years.

Orlando office investors paid an average $98.69 psf in 1999 vs. an average $107.23 psf in 1998, based on 31 transactions totaling $360.6 million. Cap rates for office building transactions in 1999 were 8 percent to 9.5 percent for class A properties; 9.6 percent to 10.75 percent for class B; and 10.75 percent-plus for class C properties.

Other second-tier markets such as Cincinnati and northern Kentucky, at a combined 30.1 million sf, are attracting attention because of new public and private construction ventures. Among them is the $404 million Paul Brown Stadium, home of the Cincinnati Bengals. On the drawing board for downtown is a multimillion-dollar reservations call center for Delta Air Lines.

“The Cincinnati market is fairly strong at this point due, in large part, to the overall growth in the economy of the Cincinnati/northern Kentucky region,” says Gregory Vollman, vice president/sales and an investment specialist at West Shell Commercial Oncor International in Cincinnati.

Class A space is tight with a vacancy level of 4.6 percent. Class B space is at 12.6 percent; class C at 14.9 percent.

The 18 million-sf Memphis, Tenn., market remains vibrant but isn't boasting a high volume of new office construction just yet. Most growth over the past few years has occurred in the city's north and southeast submarkets. Downtown has seen some redevelopment and likely will see a moderate increase in the near future. But don't look for a rash of speculatively built ventures in this market, brokers say.

“While Memphis has enjoyed a healthy growth in its office market, most of this new development has come from either local or longtime Memphis developers,” says Hank Martin, CCIM, an affiliate broker at NAI/Saig Co. in Memphis.

About 500,000 sf of class A construction is under way, closely paralleling the total absorption of 450,000 sf in 1999.

The 20 million-sf, 165-building Tulsa market also isn't seeing a whole lot of new construction, either in the CBD or the suburbs — even though class A office stock is approaching 95 percent occupancy. And lease rates have not been affected by the occupancy squeeze either. Again, the reason largely is land ownership.

“With the ownership of a significant portion of the competitive market in the hands of a relatively small number of investors, no one has stepped out to aggressively push rents,” notes Angela West, CCIM, a broker at CB Richard Ellis in Tulsa. “Satisfied with their risk/return ratios, owners are keeping rental rates artificially low, even in first-class properties,” she says.

Understandably, “The economics of speculative construction will deter significant activity” by outside developers, she adds.

CBD vacancies at year-end were 12 percent, just slightly higher than 1998. But suburban submarkets shot up 2.5 percent, approaching 15 percent.

The 181 million-sf central and northern New Jersey office markets show an overall vacancy level of 12.1 percent, with class A space at 10.7 percent. Those numbers are up slightly from year-end 1998 when overall vacancies stood at 11.1 percent and class A at 9.1 percent. Asking rents are $22.68 psf, up from $21.10 psf in 1998. Class A rents are $24.22 psf, up from $23.05 psf in December 1998.

“The slight rise in vacancy is attributable to new construction and corporate buildings becoming available, as a result of merger activity,” explains Paul Giannone, CCIM, a principal at Woodbridge, N.J.-based JGT Co. The cost of new construction also has helped move the average asking rent higher as well.

“In some cases, there is a $6 [psf] to $8 psf premium for new buildings,” Giannone says. “At full employment, one would expect net absorption to stabilize. However, New Jersey has and will continue to see many tenants migrating from Manhattan to the New Jersey waterfront where labor, taxes, utilities, and rents are 15 percent to 30 percent less expensive.”

In the Omaha-Lincoln, Neb., area, the 17 million-sf office market is seeing strong interest from investors in single-tenant leased facilities. “One factor is that a number of companies are buying their facilities … and continuing to lease the excess space,” says James W. Maenner, CCIM, a broker at Omaha-based Mega Corp. Lower interest rates in 1999 as well as more lenient underwriting for good credit have made this approach “a more economical alternative than ever,” he says.

Additionally, some public companies are buying buildings with no leverage as another tool to fend off unwanted takeover plays. “A second factor is that a number of buyers of office buildings in the early to mid-'90s have seen very nice increases in values and are [now] taking profits,” he says.

Financing Tied to Feasibility
As the renderings come off the drawing boards, developers discover that finding adequate financing for new construction is challenging these days.

“Unlike the lending conditions a decade ago, banks no longer are offering loans of 100 percent of project value,” says David B. Blenko, president/CEO of Haverford Capital in El Segundo. “They want to transfer the risk to the equity and mezzanine [bridge] portions of the financing — essentially using them as a cushion.”

At the same time, “equity and mezzanine players are taking a harder look at the feasibility of potential development and bringing more discipline to the market,” he adds. The result is “a more balanced market, in terms of supply and demand, which is reducing the supply of marginal properties that can negatively impact our economy's health.”

Lenders today generally require a 30 percent to 50 percent equity stake before signing off on construction loans for speculative projects. “There are a couple of exceptions,” Blenko says. “If a project has been largely preleased, lenders will drop this requirement. And if the project offers recourse to a strong individual investor or borrower, this equity requirement may be as low as 10 percent to 15 percent.”

Investors Search for Profits On the investment side, new trends include companies shedding real estate investment trust noncore assets, escalating financing costs, additional joint venture transactions between REITs and investors, and a reduction in portfolio sales of properties. All this adds up to higher costs and less profit potential for investors.

Nevertheless, McNamara says good buys still abound. “The office market is basically in equilibrium,” he says. “There are still a lot of opportunities out there, but those opportunities are being scrutinized a lot more carefully than they were a few years ago. That's because when you look at what the buildings are trading at, for the most part, on a price psf basis, it's easier to make a mistake today than it was several years ago.

“Basically, you could get a pretty good yield … when buying an office building three or four years ago,” he adds. “Today, while buildings in most markets are rented at the market, or pretty close to the market, there is more of a quality and quantity of due diligence being done, as it relates to the economic aspects of the transaction.”

Atlanta, Austin, Fort Worth, Indianapolis, and Sacramento, Calif., are among the second-tier markets attracting investors. “We've done (property acquisition) deals in these markets, so we know the opportunities are there,” McNamara says, “but they have to be underwritten carefully.” Location is “obviously very key.”

In the Midwest, Chicago and Columbus, Ohio, also offer some good deals for investors, Evans says. Chicago is “a cheap market relative to replacement cost, due, in part, to lackluster leasing performances at times,” he says. Columbus, too, is “cheap and stable economically.”

Foreign interest in the U.S. office market remains strong, but the players have changed. German investment teams such as the Paramount Group, DEGI, and Jamestown lead the foreign investors looking to improve returns. “They are very keen on Manhattan, cherry-picking the trophy properties,” Evans says.

But British and Japanese investors, equally aggressive in past years, are nonexistent today in the greater New York office market, he adds. Traditional solid buildings are attracting pension fund investors. “More opportunistic or class B buildings generally go to private partnerships,” he says.

In Florida, a favorite foreign-investment turf for the past two decades, interest has been only lukewarm. Far East investors usually scouring the sun-filled territory for bargains are almost invisible this year. Only the Germans are knocking on doors.

“The reason is that German yields at home of 5 percent to 6 percent are much lower than in the United States [7 percent to 9 percent] where the real estate market is much more stable,” Rogg says. “The [current] currency market [conditions], plus the devaluation of the deutsche mark makes U.S. investments more attractive.”

And, even though REIT stock prices generally have been down in the last two years, certain REITs remain big players in the office market. For example, Chicago entrepreneur Sam Zell's Equity Office Properties was scheduled to close a $4.6 billion stock, cash, and debt deal this summer to purchase New York-based Cornerstone Properties. Considered one of the biggest transactions in real estate annals, Equity would pay $1.1 billion cash, take on $1.8 billion in debt, and pay the balance in Equity stock.

Market gurus are watching the deal closely because it takes place at a time when few mergers or acquisitions of public real estate companies are occurring.

Will Office Go Virtual?
While investors and developers remain sold on office properties, others believe the offices of today will slowly disappear. “Businesses … face a new reality, and much of it is virtual,” says David Beale, founder/president of New York-based Vantas, a global executive-suites organization. “Fostered by technology that allows any space, anywhere, to serve as a place to do work at any time and pushed by fiercely competitive global economic forces that leave little margin for error and less for unnecessary overhead, the office of tomorrow will not be the office of yesterday.”

Joe Wallace, chief financial officer of Dallas-based HQ Global Workplaces, an international executive office space developer, says he believes that the hoteling trend will continue for several reasons.

“The demand for increased outsourcing of real estate has been a great driver of our business,” Wallace explains. “And the inexorable march toward efficiency may drive the [predicted] amount of space per worker down,” eventually dampening the absorption of future new office space in some markets, he concludes.

His company already is seeing an increase in the density use of its 350 centers worldwide. “We get new demands every day for dense configurations of people and technology,” he says.

Some industry professionals see the transformation from a traditional to a virtual office workplace as a plus for future space demand.

“The negative absorption rate associated with those choosing to work out of a virtual office has been more than offset by the demand for new office space, with modern technology catering to the electronic worker and executive suites,” says Douglas E. Driver, CCIM, a Trammell Crow Co. investment services associate in Boca Raton, Fla.

Ned O'Hearn, executive director of Washington, D.C.-based Oncor, agrees. “It doesn't appear that the growing acceptance of the virtual office is impacting demand for [traditional] office space,” he says. “The value of regular interaction among workers and centralized service functions are among the many reasons why I believe that the movement of certain workers into nontraditional settings will not significantly change market dynamics in the short or long term.”

Alex Finkelstein

Alex Finkelstein is a free-lance writer based in Eustis, Fla., who has covered the real estate industry for several publications.

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