Office

Office Towers

Investors scale secondary markets as prices in this sector reach new heights.

A s the U.S. added 2 million jobs to the economy during the last 12 months, office vacancy rates in major markets fell to their lowest point since 2001. Although job growth moderated during 2006's first half, the office market is in a classic recovery, according to Grubb & Ellis, with vacancies falling for eight consecutive quarters, absorption strong, construction modest, and rental rates moving upward in a growing number of cities. Indeed "net absorption of office space nationwide during this year's first quarter outpaced new additions to the supply base by nearly a factor of three," says Grubb & Ellis senior vice president Robert Bach.

"Rent growth in commercial space is gaining traction," adds David Lereah, the National Association of Realtors' chief economist. "But there are concerns over energy costs, rising interest rates, and slower-than-expected job growth that could dampen future demand."

Already the office market is moving beyond major markets, gearing up in some midsize U.S. cities. Burgeoning tenant demand by local employers continues to absorb space vacated during the downturn a half-decade ago. And the pendulum swing back toward landlords is beginning to firm up effective rental rates and spawn the genesis of another development wave.

But this recovery may be a mixed blessing for office investors. In the past year, millions of commercial real estate dollars exited high-priced major markets for better deals in secondary markets. That investor frenzy drove up midsize market prices, but real estate-happy buyers paid them, putting their faith in increasing job growth and lack of competitive new space. However in today's stop-and-start economic climate, future value gains may stem more from improved occupancy and rising rents. If that's the case, will second-city investors be stuck between slowing job growth and increased competition from new developments?

National trends don't really tell the story, as smaller markets tend to follow logic attuned to local conditions. The actions of a major employer can have a greater effect on a local office market than federal interest rate increases. And corporate site selectors can be wooed by low traffic congestion as well as costs per square foot.

As a result, the picture varies across the continent. Central business districts in some secondary markets are seeing ambitious development activity even in the face of significant tenancy losses. Meanwhile economics in other CBDs probably won't support additional development for another year or two - or longer.

Midsize market activity today also reflects considerable contrasts in tenant needs and preferences. While small infill projects in some cities cater to equally small growth in space demand, other locations are accommodating jumbo-size space users. Meanwhile in other markets, entrepreneurs and professionals are snapping up free-standing single-user offices at a head-turning pace and price.

That variety may be the saving grace of investors wise enough to vary their office portfolios geographically. A look at office market trends and activity in a half-dozen secondary markets spanning the nation offers a glimpse into the opportunities and challenges found at the local level.

NORTHEAST

Wilmington, Del.
Employer M&As Create Uncertainty

Several optimistic local developers remain quite bullish on the Wilmington, Del., marketplace despite near 16 percent vacancies and uncertainties about a major tenant's long-term presence here, observes William B. Elliman, CCIM, SIOR, a partner in GVA Smith Mack.

As in many midsize markets, Wilmington landlords are particularly exposed to a key industry: financial services. While the banking business is strong these days, it's also consolidating, which explains the angst Elliman and other commercial real estate pros in Wilmington's CBD feel.

The big question mark pertains to Bank of America Corp.'s recent acquisition of MBNA Corp., Elliman says. It's still unclear what ultimately will become of the 3.3 million square feet of office space the institutions occupy here, but consolidation elsewhere clearly would put a lot of occupancy pressure on Wilmington's CBD.

Meanwhile the downtown already faces cutbacks. With PNC Financial's departure from four-plus floors at 222 Delaware Ave., downtown class A occupancy shrank by 132,000 sf in the first quarter, Elliman reports. That helped push Wilmington's overall vacancy rate up to 15.8 percent, slightly above the CBD rate.

While Wilmington/New Castle County's northern suburbs are mired with vacancies at close to 20 percent, Elliman cites southern New Castle County as a bright spot. Strong class A leasing in that submarket has knocked vacancies down sharply to 11.5 percent.

Despite downtown Wilmington's recent and potential tenancy losses, some noteworthy and costly developments are on the way. Developer and lender optimism apparently reflects defiant upward movement in rental rates even amid the negative absorption and uncertainties surrounding the Bank of America/MBNA space. Asking rents marketwide posted an average gain of more than 50 cents during the first quarter to $22.70 per square foot, with class A average rents up 8 cents to just under $24.50 psf, according to Grubb & Ellis.

That's encouraging news for Buccini/Pollin Group, which already has preleased nearly 60 percent of its 350,000-sf 500 Delaware Ave. tower slated to open in November. Major tenants are WSFS Bank and law firm Morris James Hitchens & Williams. Principal Christopher Buccini says the early signees are willing to pay the $32 psf needed to justify development costs.

Meanwhile down the street at 800 Delaware Ave., Delle Donne & Associates is nearing completion of the Corporate Plaza 150,000-sf expansion to house tenant Blue Cross Blue Shield's growth. Similarly, Pettinaro Enterprises is finishing up a nearby 250,000-sf build-to-suit development to accommodate the expansion of Barclays Group unit Juniper Bank.

Elliman also notes that The Commonwealth Group is preparing to break ground (with no prelease commitments) on downtown's Renaissance Centre, which will include as much as 150,000 sf of office space. And Buccini/Pollin has a pair of 150,000-sf office buildings planned as part of its $500 million, 1.3 million-sf mixed-use community getting underway along downtown's riverfront.

SOUTHEAST

Nashville, Tenn.
Employers Go South for Bright Lights Without Worries

Like Wilmington, Nashville's CBD also is anticipating a development wave amid concerns about major tenants. But the hottest action here is in the suburbs, in particular the Cool Springs/Franklin submarket 20-some miles south of downtown.

With 880,000 sf of class A build-to-suit activity and another 660,000 sf of speculative development going up, the roughly 3 million-sf submarket's supply base is quickly expanding by 50 percent, reports Whit McCrary, CCIM, principal at Colliers Turley Martin Tucker in Brentwood, Tenn.

Most notably, Nissan North America's $70 million, 450,000-sf U.S. headquarters is in progress. Also under construction nearby are Healthways' 255,000-sf facility and Community Healthcare Systems' 175,000-sf headquarters.

Highwoods Properties, which is developing the Healthways complex, also is putting up the 153,000-sf Cool Springs III spec development. And Crescent Resources has a pair of 150,000-sf projects under construction and may well get another one out of the ground soon.

Exceptionally low vacancies in some of Nashville's traditional close-in suburban submarkets are pushing activity into Cool Springs and the surrounding areas, explains David Koziak, CCIM, associate broker at Grubb & Ellis/Centennial. Large leases reflect pent-up demand from new and existing tenants as developers had been "slow to bring new product to market" since the last big boom ending early in the decade, he says.

The slow period is fading fast as Nashville's marketwide class A vacancy rate just eased into single digits, with the overall rate a shade under 12 percent and falling. Asking class A rents now range from $17.50 psf to $27.50 psf, with the CBD topping out at close to $22 psf. Class B rates are generally between $13 psf and $18.50 psf, Colliers Turley Martin Tucker reports.

What's behind all the user-side demand is Nashville's quality of life, reasonable costs, and strategic location. That combination attracts numerous corporate headquarters and large operations, especially in service, education, healthcare, and administrative support industries. Meanwhile downtown Nashville is rapidly moving toward 24-hour city status with a residential, entertainment, and cultural renaissance.

However, mergers are raising yellow flags about the office market's supply/demand fundamentals. In particular, BellSouth had been looking to sublease its downtown offices even before its merger with AT&T. Fortunately for downtown landlords Nissan subleased about 130,000 sf at the BellSouth Tower and leased another 110,000 sf to use until its Cool Springs facility is ready in 2008. At that point, landlord representatives will aim squarely at large users for the big swaths of contiguous offices, Koziak predicts.

Most recently big local players AmSouth Bancorp and Regions Financial agreed to merge, implying additional downtown give-backs, McCrary laments. Activity at space vacated by BellSouth and the merging banks presumably will have a lot to do with the pace of downtown office development, he says. Already local stalwart Eakin Partners has its 338,000-sf SunTrust Plaza underway, half preleased to the namesake bank and law firm Stites & Harbison.

Other local developers have ambitious downtown plans as well. Alex S. Palmer & Co. hopes to add a 25-story, 500,000-sf office tower to the mixed-use hotel/spa/condominium tower it's building with InterContinental Hotels. And Struever Bros., Eccles & Rouse, and C.B. Ragland Co. are aiming to participate in the south of Broadway district's revival with a series of office buildings potentially totaling 1.5 million sf.

MIDWEST

Minneapolis-St. Paul
Spec Developers Eye Tight Suburban Markets

In Minnesota's Twin Cities, dwindling supplies of quality suburban offices are just starting to prompt the next development cycle. But activity is modest, as overall vacancy rates remain in the midteens even in the suburbs. And the Minneapolis and St. Paul CBDs still have plenty of space to fill given their vacancy rates of approximately 20 percent and 22.5 percent respectively, according to Northstar Partners/Cushman & Wakefield Alliance.

In contrast, class A vacancies in the strong southern suburbs such as Eden Prairie and Bloomington are down to single digits, United Properties reports. Accordingly, Duke Realty has launched the first major spec class A project in a half-decade. The 330,000-sf Norman Pointe Tower II is rising next to Duke's Norman Pointe Tower in Bloomington. Opus Northwest also is starting construction - without a committed tenant - in nearby Hopkins on the first phase of a campus-type development totaling 600,000 sf.

Depending on the location, Twin Cities office developers might be able to pencil out a new project at lease rates below $20 psf, notes Michael Perkins, CCIM, senior vice president with NAI Welsh. But quite a bit of class B space still is available even in the suburbs, so those few active developers are eyeing mostly higher-cost class A opportunities in the tightest submarkets, he adds.

The marketwide average asking rental rate, slightly below $22 psf for the last couple of years, now is trending up, Northstar/Cushman & Wakefield reports. The class A average now is $24.50 psf, with class B at $19.30 psf. Top-tier space in stronger western and southwestern suburban submarkets can command upward of $25 psf to $26 psf. But class A CBD high-rise space averages just under $24 psf in downtown Minneapolis and a bit higher than $22 psf in St. Paul.

Perkins expects suburban development activity to pick up, as developers and lenders are confident about the Twin Cities area's steady growth, low unemployment rate of 4.4 percent, and relatively diversified economic base, showing particular strength in healthcare and high technology industries. And it doesn't hurt that the marketplace absorbed about 1.5 million sf of mostly class A space last year.

CBD landlords will "aggressively" target suburban tenants as the supply of quality space out in the suburbs continues to dwindle, Perkins says. For instance he recently helped woo financial planner Foster Klima & Co. from Eden Prairie to International Centre in downtown Minneapolis.

CBD buildings now offer some of the T win Cities' most attractive lease rates and terms, and owners are willing to use parking rates as bargaining chips. While suburban rents already are moving north, the heavier competition for lower-floor space in particular probably will prevent any significant upward movement in the CBD markets for another year or two, Perkins adds. "Then we'll see more suburban companies taking a hard look at moving to one of the downtowns," he predicts.

Equastone recently purchased these four class B office/flex properties in Austin submarkets as a value-add opportunity due to the area's falling vacancies and strong job market.
photo credit: Equastone

SOUTHWEST

Austin, Texas
Recovering Tech Companies Improve Near-Term Outlook

Even after Austin office users absorbed more than 1 million sf last year, the Southwest's fastest-growing marketplace entered 2006 with plenty of available space. But followed by a couple more quarters of brisk activity and rising rents, conditions triggering construction can't be far off, especially given expectations about near-term job growth.

While still uncomfortably high at just under 16.5 percent, the Austin marketplace's overall vacancy rate has fallen steadily and is now at a five-year low, Colliers Oxford reports. Meanwhile the average asking class A rental rate marketwide has jumped a full $3 to $23.50 psf over the past year. So it's no surprise some national prognosticators have picked Austin's office market as a likely top performer for the balance of the decade.

Akin to their peers in the Twin Cities, however, downtown Austin landlords continue to look longingly at their suburban counterparts. Downtown's overall vacancy rate remains beyond 23 percent, the fourth-highest among the nation's CBDs, according to CB Richard Ellis.

On a brighter note, downtown's class A rate is finally below 20 percent after moving well above 25 percent just a couple years back, helping push the corresponding average asking rent up to $26.50 psf. Aiding in that effort is Silicon Labs' move from the southwestern suburbs to downtown, having leased four floors with an option to buy a 221,000-sf Computer Sciences Corp.'s building.

The 33-story Frost Bank Tower was completed in 2003 when the local office market "was at the absolute bottom of this real estate cycle," notes veteran tenant rep specialist Chris Perry, CCIM, a vice president with Trammell Crow Co. Based on historical averages, the 525,000-sf structure represents some five years of CBD absorption, he adds.

But since tenant demand started turning around the following year, absorption downtown actually has been "comparable" to the suburban class, Perry continues. Hence despite the current 20 percent-plus vacancy rate, CBD landlords have generally seen effective rental rates rise gradually in recent quarters, he added.

But the Austin-Round Rock area mainly is a magnet for employers that like suburban campuses -- the big technology companies attracted to the area's quality of life and educated workforce. Accordingly, corporate expansion by such users accounts for much of the expected early-cycle development activity. For instance, Advanced Micro Devices just bought 58 acres slated for an 860,000-sf office campus in southwestern Austin's Lantana district. Meanwhile Samsung Austin Semiconductor is investing $500 million to expand and upgrade its memory chip fabrication facility in northeastern Austin and just announced plans for a multibillion dollar facility next door, which eventually will employ 2,500 workers.

But Austin's spec development remains quite modest for the moment, with less than 500,000 sf underway, mostly in the relatively tight southern suburbs, Grubb & Ellis reports. Brandywine Realty has launched a 211,000-sf development, and Hill Partners has announced a 90,000-sf project. In addition, Trammell Crow Co. and Principal Real Estate Investors have a pair of 121,600-sf buildings just under way in northwest Austin. These presumably will cater to small tenants that still account for the bulk of Austin's employment growth. Much of the growth is in telecommunications, software, semiconductors, and biotech; the film and music industries also are thriving here.

With the southwest suburban vacancy rate at 9.6 percent, according to Colliers Oxford, the area seems likely to see much of the early spec activity as development returns. Cranes presumably will appear later in the northern submarkets, where vacancies remain closer to 15 percent. With the marketwide average full-service rent at $21.20 psf and climbing, it's only a matter of time.

WEST

Inland Empire, Calif.
Businesses Trade Up to Class A

Construction activity must be brisk when the nation's tightest office market prompts warnings about potential overdevelopment. The overall vacancy rate in Southern California's booming Inland Empire marketplace is just 7 percent -- the lowest rate among the U.S. markets Grubb & Ellis tracks.

But developers likely will add more than two million sf of mostly class A space this year, augmenting the local inventory by roughly 10 percent. While that might not be a major concern in a strong-demand marketplace seeing plenty of preleasing, the emerging Inland Empire office market just hasn't evolved to the point where tenants make preconstruction commitments, says Ruby Simpson, CCIM, a Sperry Van Ness senior adviser.

Despite the "sea change" that's pushed every Inland Empire real estate category upscale over the past half-decade or so, "we're just not there yet," Simpson says. "It's hard to get tenants here to commit to a building they can't walk into."

But rising class A and class B rents and solid space absorption appear to be cushioning against the risks of over-saturation. Even without preleasing, developers leased more than 75 percent of the roughly 425,000 sf delivered during the first quarter, Grubb & Ellis reports.

Meanwhile after asking rents rose just slightly in 2005, tenant demand has helped bump up rates steadily this year. Grubb & Ellis projects that top rents will be up by double digits over the course of the year. Class A asking rents average just below $24 psf and class B just above $21.50.

Demand has become so high for top-quality, well-located offices that many tenants "who want to be where the action is are happy to pay" the top-tier lease rates required to justify ever-rising development costs, Simpson notes. Accordingly developers mostly are chasing high-end opportunities rather than augmenting the class B inventory, she says. However property owners upgrading older properties are attracting plenty of other tenants at lower price points.

For instance, near the western Inland Empire hub of Ontario, Calif., developers are seeing exceptional activity selling free-standing buildings to small-business owners. " They're selling like hotcakes," Simpson says, adding that sales prices frequently surpass the $250 psf mark. "And those prices are for the shells; they've still got to invest at least another $40 psf in finishes," she says.

Some larger developments are underway further east in San Bernardino and Riverside, including one of the biggest office prelease deals in Inland Empire history. Wells Fargo Home Mortgage preleased 230,000 sf of the 284,000 sf at Opus West Corp.'s Northpointe development within San Bernardino's growing commercial corridor.

Chino Ranch Business Park, a 33-building office/industrial complex under development in Chino, Calif., is typical of the produ
ct popular with Inland Empire, Calif., small to midsize business owners.
photo credit: Brower, Miller & Cole

NORTHWEST

Portland, Ore.
Low Rents Keep Developersat Bay

The Portland marketplace has seen class A vacancies dip into single digits amid steady absorption and scant development. Nevertheless, effective rental rates haven't yet returned to levels justifying much top-quality development activity, especially in Portland's transit-blessed CBD.

Instead, recent and current construction activity is focused mostly on small projects of less than 50,000 sf in infill sites. This also reflects the paucity of large lease transactions in the Portland market. Growth here indeed seems to be progressing in baby steps as existing companies expand, and the first quarter saw nary a deal reach the 30,000-sf mark and just one beyond 20,000 sf, Colliers International reports.

Still, the absorption trend has been solid for several quarters running, pushing Portland's overall vacancy rate below 12 percent, with the class A figure at barely 8 percent. But the activity has yet to translate into much rental-rate growth generally, as the marketwide average for all quality classes remains at just under $18 psf, according to Colliers. But average asking rents in the best buildings are up about 4 percent over the past year.

Nevertheless class A rents downtown remain well below what developers need to launch a sizable new project, especially given the recent hikes in construction costs. Rents at the best buildings are now in the mid-$20 psf range, but developers really need to count on mid-$30 psf rates at this point, says Dan R. Swift, CCIM, SIOR, senior vice president at Trammell Crow Co.

With downtown's tenants generally prospering and expanding amid the improving local economic environment, Swift thinks CBD rents should rise sufficiently over the coming year to get downtown's next tower out of the ground. "I'm confident we'll see a new class A building break ground within the next 12 months," he says.

Most likely downtown's first 21st-century addition will be the 15-story, 350,000-sf project proposed by Equity Office Properties and local powerhouse Gerding/Edlen Development at First and Main. Meanwhile Equity Office has launched the biggest project underway in Portland's suburbs, the 107,500-sf Kruse Oaks II scheduled to open in November, in the high-end Kruse Way district south of the CBD.

Given the low vacancies in the Kruse Way area, comprising the submarket known as I-5 South, it's no surprise the area is capturing more than half of the Portland marketplace's current office construction. The class A rate here is hardly 5 percent and the overall rate is below 8 percent. As is the case elsewhere, larger tenants relocating from outside Portland logically will look first to the suburban submarkets, Swift says.

Brad Berton

Brad Berton is a freelance writer in Portland, Ore., specializing in commercial real estate and development issues.Whit McCrary, CCIM, (left) and Robert Lowe, CCIM, of Colliers Turley Martin Tucker in Brentwood, Tenn., represented Spheris in a 10-year, 79,209-sf lease in the Primus complex in Cool Springs/Franklin, Tenn., Nashville\'s hottest office submarket. Inland Empire, Calif.\'s small-business owners are buying free-standing buildings at around $250 psf. "And those prices are for the shells; they\'ve still got to invest at least another $40 psf in finishes," says Ruby Simpson, CCIM, Sperry Van Ness senior adviser in Pasadena, Calif.

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