Philadelphia's commercial real state market is robust and thriving despite changing conditions which generate challenges anew. In 1997, Center City office vacancy rates were still declining and some eager developers were probably visualizing potential new office towers. A year later, corporate mergers, downsizing, acquisitions and relocations have already begun returning upwards of 1.8 million sq. ft. of office space - according to various estimates - to the marketplace for sublease.

"We'd reached the lowest office vacancy rate of 13.2% in this decade," explains William G. Luff Jr., senior managing director, Mid-Atlantic area for Cushman & Wakefield. "Now it's increased 1.3%. Yet, rental rates are also rising, the average at $23.58 per sq. ft. - up 50 cents for Class A space in the first six months of this year."

C&W puts midyear leasing activity in the CBD at more than 804,000 sq. ft. compared to some 1.9 million sq. ft. for all of 1997. Luff attributes the anomaly to the fact that, while the sublease facilities coming onto the market may be Class A space, they are not always the best or classiest buildings in the CBD. "Also, new owners such as real estate investment trusts and institutions, which have purchased buildings at viable numbers, are not hard-pressed by negative market factors to lower rental rates."

There's plenty of real estate activity in Philadelphia and its suburbs, says Walter D'Alessio, president and CEO of Legg Mason Real Estate Services, a mortgage banker. "Philadelphia is an attractive market for investors. A lot of the larger buildings have changed hands recently, purchased by national investors, and with values starting to rise, large REITs and individual investment groups are vying for Center City office properties."

D'Alessio notes that the city's northern and western suburbs are seeing some speculative office construction simply because those markets are so strong. "But that volume is not significant."

Philadelphia's suburbs, an office market of about 30 million sq. ft. is very tight, according to J. Richard Jones, president and CEO, Insignia/ESG Jackson Cross. "The overall vacancy rate is a little under 10%, with some areas as low as 3% to 4%, and especially tight in Bala Cynwyd, Radnor, Conshohocken and sections of the 202 corridor and Plymouth Meeting," he reports.

And rents are higher than ever, says Jones, citing $27 to $28 plus electric of about $1.50 per sq. ft.. "The supply is not coming on as strong as the demand, but some build-to-suit projects do reduce the pressure," he states. Also not helping meet regional demand are declining space availabilities in South Jersey, across the Delaware River.

Downtown is transformed Downtown Philadelphia continues its transformation as a people center. Buildings are being converted from office to hotel and rental residential uses. Some 2,000 more hotel rooms also are planned by the year 2,000. "New law firms and other service industries are growing in the CBD, and the city's economy is being driven by the successful convention center, more restaurants, retail, more entertainment facilities, plus a cultural center has been funded," says Jones.

Peter Talman, director of leasing for The Rubenstein Co., maintains that expanding local firms will help absorb the growing inventory, along with an influx of outside companies relocating here. "One in five prospective tenants seeking space in our buildings is a newcomer to Philadelphia with needs in the range of 10,000 sq. ft."

Typical, says Talman, was the Kvaerner transaction, which involved 30,000 sq. ft. of offices earlier this year. The Norwegian shipbuilding firm received a lot of press when it signed a 99-year lease for the Philadelphia Shipyards.

Some 900,000 sq. ft. of new office construction is under way all across the Philadelphia suburbs, according to Talman, which will soften vacancy rates and hold rental rate increases - up some 10% in the past 12 months - in check.

"While mergers and acquisitions will result in the availability of almost 2 million sq. ft. of sublease office space, we can't consider that space as vacant," says Clive Mendelow, vice chairman of Binswanger Realty Group. "Those landlords are still getting their rents, but we won't see any new office construction in the city for the foreseeable future. There's no need for panic. I'm cautiously optimistic about the city's ability to absorb the vacancies as they occur."

"Philadelphia's real estate market continues to display surprising underlying strength in demand for office space," maintains Timothy Pulte, senior vice president/sales manager, Grubb & Ellis. "In the first six months of 1998, 900,000 sq. ft. of sublease space was added to the available supply. Negative absorption, however, was only 293,000 sq. ft., with positive growth accounting for 481,000 sq. ft. in leases."

Pulte reports the CBD now contains more than 5.5 million sq. ft of vacant office facilities, with future space for sublease adding another 750,000 sq. ft. to that inventory over the next six to 18 months. And, he notes, a number of Class A buildings continue to record occupancy levels of more than 90%.

Among major investment sales/acquisitions this year were the purchase by HRPT Properties Trust, a Newton, Mass.-based REIT, and a Grubb & Ellis client, of the multitenant Mellon Bank Center of 1.2 million sq. ft. for $226 million; as well as 1600 Market Street, an 800,000 sq. ft structure anchored by PNC Bank.

HRPT, in its first foray into the Philadelphia market, also acquired the 24-story building where SmithKline Beecham makes its headquarters. SmithKline also has taken all the space in a build-to-suit office project now under construction contiguous to its headquarters, according to Andrew Rudzinski, Grubb & Ellis research chief. The build-to-suit is being developed by Liberty Property Trust, a Malvern, Pa.-based REIT.

Mack-Cali Realty Corp., the Craford, N.J., REIT, also is a major player, primarily in the suburbs. Reports Jim Nugent, leasing vice president: "Mack-Cali, in the Philadelphia market since 1996, has had great success with our investments. Rents have been rising and we've increased the occupancy rate of our holdings. Currently we own approximately 1.4 million sq. ft. of Class A office property in the market, and we will continue to explore opportunities that are accretive and show upside potential."

Conversions generate activity Demand in the hospitality sector generates new product via the conversion route - not new construction. The PSFS Building is being converted to a 590-room Loews hotel by the Rubin Organization, a $105 million project. According to Peter Talman of Rubenstein, One Penn Square is under construction for conversion to a high-end, first-class hotel to be delivered next year.

Apartment conversions include 1411 Walnut Street, formerly the Exchange Building, which will have a Mellon bank branch and Morton's restaurant at ground level. Reported in the wings are additional residential conversions at 100 South Broad Street and 1300 Chestnut Street, along with part of the INA building at 16th and Arch streets.

The region's industrial market remains strong, with significant leasing activity in the first half of the year, with average per sq. ft. rentals averaging $3.70 for warehouse/distribution space and $6.75 for office/flex facilities - up fractionally from last year.

Activity also pervades the retail sector in downtown Philadelphia. A building occupied by Mellon Bank is reported to be moving towards conversion into an elegant Lord & Taylor store. The site is opposite Kaufmann's Department Store and near a new Lazarus retail unit scheduled for a mid-November grand opening. Plans also call for a doubling in size of the Saks Fifth Avenue store in the Forbes and Fifth Avenue posh retail corridor.