The Suburban Scene
Parking and Shorter Commutes Attract Companies to Outlying Office Markets.
Despite the trend toward downtown revitalization, suburban locations still find favor with many office tenants. Financial, telecommunications, and technology companies in particular view the suburbs as an attractive location for corporate headquarters, call centers, and back offices.
Convenience continues to be the main impetus behind the exodus out of central business districts. As new interstates and freeways open areas of development and residential growth pushes farther away from city limits, many companies relocate to be near their customers and job pools. In San Antonio, Texas, for example, companies are following residents as they move to the northwest, north central, and northeast corners of the metropolitan area, according to Kimberly S. Gatley, director of research for REOC Partners.
The situation is similar in other parts of the country. “In [the Detroit] region, the majority of the population lives outside the central city,” says Christopher G. Secontine, CCIM, associate broker with Signature Associates in Southfield, Mich. “In fact, many live quite a distance, so location as it relates to the labor pool is stressed more often now than, say, 10 or 15 years ago.”
In Orange County, Calif., “As new homes are constructed in locations previously deemed geographically inconvenient, new offices ... will be built,” says Timothy B. Good, senior managing director of the Investment Properties Group at the Charles Dunn Co. in Irvine, Calif. “The Orange County areas that will see the greatest growth in housing are South County to the San Diego County line and East County toward the Inland Empire. Office buildings will follow.”
In Wichita, Kan., where medical office development is abundant, large health-care groups are moving to the suburbs to be closer to their patients and families, says Timothy Goodpasture, CCIM, president of Goodpasture Real Estate Group.
Companies located in suburban areas also can offer their employees amenities that are difficult to find in CBDs, such as free parking and open space.
“Parking is the biggest problem for downtown office buildings,” says Patrick E. Coates, CCIM, marketing director/broker at Kennedy-Wilson Property Services in Tulsa, Okla. “Parking is perceived as an expensive hassle to downtown visitors and customers. Almost every Tulsa multi-tenant suburban office building has no charge for garage or surface lot parking.”
Yet for all their convenience and amenities, suburban locations are not immune to the problems afflicting CBDs. Decreasing demand and plunging lease rates plague even the most stalwart suburban office markets. Commercial real estate professionals agree: The recession's effects still linger.
Smaller Is Better
Fortunately there is one bright side in suburban office markets: Leasing and sales activity is improving for small-scale deals.
In suburban Orange County many small office buildings “are being purchased or leased by tenants, creating a positive absorption in the marketplace,” says Chris Deason, a broker with Voit Commercial Brokerage in Irvine. While overall sales prices remain stable, prices for small suburban buildings have increased since first-quarter 2001, he says. “The velocity of leases is greater for tenants in the 10,000-square-foot or less spaces,” and most vacancies are for larger space, Good adds.
Since most big corporations are waiting to make space decisions, fewer large-block deals are occurring in suburban New Jersey, says Roger Steinhardt, director of commercial leasing for Kushner Cos. in Florham Park, N.J. His company's small-space properties are experiencing “fairly good activity,” he says.
In suburban Montgomery, Ala., most office park leases are between 5,000 square feet and 20,000 sf, says Mickey Griffin, CCIM, director of corporate services for Aronov Realty. Strategically located near freeways and retail areas, these parks attract companies such as ING Life of Georgia and Mutual of Omaha insurance companies, he says.
Likewise, the trend is toward small space in suburban Miami, and these properties contribute to high occupancy rates in areas such as South Coral Gables, which boasts a 1 percent to 3 percent vacancy rate, says Kenneth D. Rosen, CCIM, of Kendar Realty in Coral Gables, Fla.
Too Much Space, Too Few Tenants
Despite good news in small-scale deals, problems plague the national suburban office market. Due to corporate consolidation, downsizing, and bankruptcies, massive amounts of sublease space have hit the market in the past year. Nationally, the number of sublease square feet in suburban offices more than doubled from first-quarter 2001 to first-quarter 2002, from 42.5 million sf to 94.2 million sf, according to CB Richard Ellis, causing vacancy rates to skyrocket in many markets.
Available sublease space has tripled in Kansas City's suburban markets during the past year, from 315,000 sf to 1.1 million sf, says Carolyn Bagnall, a research associate at Colliers Turley Martin Tucker. Space consolidations by large corporations such as Sprint have contributed to a 17.4 percent vacancy for the entire Kansas City suburban office market, she says.
Overflow from excessive new development during the dot-com boom exacerbates the space glut. “With the technology collapse ... companies had more space than they needed and landlords had leases with companies that had no equity and no business prospects,” says Ray Zabielski, CCIM, a senior associate at Sperry Van Ness in Naperville, Ill. “With all that space coming back on the market, whether as sublease space or as defaulted leases, there was an enormous increase in supply.” In Chicago's western suburbs the direct vacancy rate is 13.5 percent, 17.5 percent including sublease space.
Sublease space increases suburban Portland's vacancy rate to nearly 20 percent, according to Chris Johnson, executive vice president and partner at Norris, Beggs & Simpson. The suburban vacancy rate is higher than the CBD rate, despite a business tax companies must pay to locate downtown.
More than 1 million sf of sublease space inundated suburban Indianapolis, contributing to an 18.5 percent vacancy rate, says Drew Augustin, CCIM, SIOR, president of NAI Olympia Partners. Corporate consolidations are the main culprit for the excess space. Yet interest in the suburbs remains high due to parking costs and real estate taxes that almost double rental rates in downtown Indianapolis, he says.
Companies downsizing and relocation within the market are affecting suburban Minneapolis, says Jill Rasmussen, CCIM, senior vice president of Northco Corp. In an office market comprising 14 million sf, approximately 13.5 percent is vacant -- not including 1 million sf of sublease space -- up from 11 percent at the end of 2001. Although leasing activity is moderate, “there is a lot of shifting, which is not good true absorption,” she says.
Along with corporate downsizing, economic uncertainty has slowed leasing activity in many suburban markets. “Apprehension in real estate is like oil and water; it curtails demand,” says Dean J. Shapiro, executive director of Insignia/ ESG in Elmsford, N.Y.
In the Southwest, “many tenants continue to postpone space decisions until they can get a read on the economy,” says Scot C. Farber, CCIM, director of CSFB Realty Corp. in Dallas. The same is true in suburban Philadelphia, where “we continue to see businesses showing reluctance in making long-term commitments regarding capital spending, hiring, and office space,” says Mitchell E. Hersh, chief executive officer of Mack-Cali Real Estate Corp. Instead of expanding leases, tenants are renewing them for shorter terms, he continues.
Short-term leases currently are in vogue, as companies assume a wait-and-see attitude. Also, “corporate America [is] trying to be as flexible as possible,” says David R. Krumwiede, executive vice president of Lincoln Property Co. in Phoenix. However, short-term leases are not always smart, “because in two to three years the rates will be higher,” Secontine says.
Landlords must be creative to keep their properties occupied and meet tenants' needs as well. To stabilize lease rates, they increase concessions such as tenant improvement allowances, moving expenses, shorter renewal terms, and free rent. “On five-year lease commitments, tenants [in Tulsa] are receiving a month of free rent as a bonus incentive for the longer term,” Coates says. In Phoenix, where lease concessions were “nonexistent in 2000 and 2001,” landlords now are offering early occupancy and tenant improvement and relocation allowances, Krumwiede says.
The competition from sublease space isn't helping landlords. In many cases, sublease space is more appealing than direct space because it generally is below market rent, comes fully functional, and offers shorter, more flexible lease terms.
In Orange County, “more sublease space has become available as large Fortune 500 firms temporarily downsize,” Deason says. “They are able to offer aggressive short-term lease rates that are 15 percent to 20 percent below market rates.”
Similarly, in Atlanta's suburban market, “the large supply of sublease space is allowing tenants to relocate to comparable buildings at discounted rates,” a trend that will continue until companies stop downsizing, reports C. Anderson Bell, CCIM, president of Anderson Bell.
In Portland's suburbs, more deals are occurring in sublease than direct space as sublease landlords try to cut their losses, Johnson says. To compensate, landlords are offering up to six months free rent in some submarkets, he says.
Sales on the Slide
Like leasing, sales activity also has decreased during the past year, mainly due to a gap between sellers' expectations and buyers' resources.
This disparity halted several major projects in the Kansas City area last year. “A lot of packages were put together that just didn't happen,” says William W. Dorsey, CCIM, managing principal of Colliers Turley Martin Tucker. Properties that are selling have long-term anchor tenants with good credit, are part of 1031 exchange transactions, or are user sales.
The bid/ask spread between buyers and sellers in the Philadelphia suburban market also is greater than normal, leading to a slowdown in investment sales activity, Hersh says.
Orange County suburban markets also have experienced a drastic decline in sales transactions, Good says. Cap rates have increased 50 basis points to 100 basis points, “as investors have adjusted their yield expectations to reflect their perceptions of lease risk,” he says. Notable recent sales in the Irvine area include the 189,452-sf 4100 Newport Place for approximately $43.7 million and Opus Center Irvine Phase 1 for approximately $70 million, he says.
Sales aren't occurring in the Phoenix area because property owners “see the light at the end of the tunnel,” although sales prices currently are soft, Krumwiede says. When occupancies rise and the growth curve increases, owners once again will put their properties on the market.
On the other hand, buildings are selling in some suburban markets due to the current low interest rates. “Right now is a good time to buy if you can find the right deal in the right suburb,” Rosen says. However, few buildings are for sale in Miami's southern suburbs, especially South Coral Gables, Coconut Grove, and South Miami, because office space is an extremely desirable investment due to the area's high appreciation rate, he says.
At the Executive at Whitetail, an office park in northeast suburban Wichita, companies are more interested in purchasing than leasing, says Goodpasture, who is developing the project. “Many of the companies I am talking to are considering buying a building, occupying a portion, and leasing out the balance to offset expenses.”
“Spec Is a Four-Letter Word”
With the glut of space on the market, development practically is at a standstill. Until positive absorption numbers are reached, lenders continue to turn down speculative new construction deals.
“Spec is a four-letter word,” says Robert M. Chapman, executive vice president, southern region, of Duke Realty Corp. in Atlanta. “It is suicidal to be building a new building right now.”
All over the country, suburban office developments are stalled in the planning stages due to lack of tenants. In Indianapolis, few planned projects have started construction, and “a lot of backfilling of existing space will need to occur before any new construction begins,” Augustin says. Several projects in Westchester County, N.Y., have been in planning for a long time and most likely will stay that way until developers can find tenants, Shapiro says.
But projects with significant pre-leasing are moving forward. For example, Koontz McCombs started construction on the 67,000-sf Two Twin Oaks in San Antonio after Allstate signed a multiyear lease for more than 50,000 sf, Gatley says.
“For the most part, we are seeing developers securing an anchor tenant prior to construction,” Deason says. “Building strictly on spec without pre-leasing these smaller suburban office buildings is too risky in the current environment.”
Build-to-suit construction will dominate the development arena for the next year, especially by “users who want more specialized applications than what is available,” says Charles A. Anderson, senior executive director of Trammell Crow in Dallas. Companies also are building more space than they need and leasing out the remainder, Goodpasture says.
Luckily, the current national suburban office market hasn't been hit as hard as it was during the early 1990s real estate recession. This recession “wasn't deep enough to push tenants out,” Secontine says. “By no means is it all doom and gloom.” Although a few years ago heavy construction contributed vast amounts of space, little new space currently is coming on the market, which helps to expedite absorption.
Existing space quickly will fill once the economy turns, Steinhardt says. Until then, development will continue to slow, and lease rates will continue to decline as landlords fight for the few available tenants.
However, a recent pickup in activity suggests that the market is in an upswing, and some experts predict a quick recovery. “While tenant demand [in Philadelphia] has been weak for the past year, activity has picked up over the last two months,” Hersh says. He expects the recovering economy, increased corporate spending, and suburban Philadelphia's diverse industry base to help the market stabilize by early next year.
Suburban Chicago's office market also experienced increased leasing velocity during the second quarter: 2.1 million sf of the 2.3 million vacant sf was leased, Zabielski says. “The sublease space coming on the market has stabilized, and by 2003 it should be almost all absorbed,” he predicts.
Leasing activity in Phoenix picked up dramatically in April and May, with many tenants negotiating leases that should “turn to ink in the third quarter,” Krumwiede says. “We will hopefully be back to 2001 activity by 2003,” he says.
In some cases, recovery may take a little longer than a few months. Although the Omaha suburban office market recently has stabilized, it will take 12 to 24 months for it to be in “reasonable balance,” says Stephen M. Farrell, CCIM, president of Investors Realty. “The formation of new suburban business areas likely to generate a significant concentration of new office development shows no sign of occurring in the immediate future.”
“It will be some time before the market gets back into equilibrium,” Shapiro concurs. Current market conditions in New York's Westchester, Fairfield, and New Haven counties are “anemic,” but demand slowly will return, he predicts.
In the near future, “the businesses that will prevail are doing the right thing: moving on and becoming creative instead of responsive,” Bell says. “ A smart owner is asking ‘Let's figure out what we do now.' As this occurs, the market will absorb the subleases and then the numbers will turn around.”
In the meantime, commercial real estate professionals across the country wait patiently and remain optimistic.