In the heart of downtown Phoenix, near Washington Street and Central Avenue, stands a reminder of the office market's glory days. When they opened in 2000, the Phelps Dodge Tower and Collier Center — a collective 921,000 sq. ft. — were celebrated as the first new high-rises to grace the city's downtown since 1991. As it turned out, they were also the last.

Metro Phoenix's office market tanked the very next year, and has been struggling to recover ever since. The 19.4% vacancy rate for all classes of space notched in the second quarter of this year nearly doubles the 9.9% recorded by CB Richard Ellis in 2000. Why has the vacancy rate spiked so dramatically? For starters, 3.7 million sq. ft. of space began to come on line in 2001 just as the country slipped into recession. And in uncharacteristic fashion, the market experienced negative net absorption of 27,590 sq. ft. in the same year.

The resulting glut has depressed office rental rates for all classes of space nearly 10% from their peak of $20.54 in 2000, and spurred a game of musical chairs as tenants use their bargaining power to score free rent, concessions and discounted space.

Elliot Pollack, a Phoenix economist and real estate analyst, speculates it will be at least 2007 before office vacancies return to a healthy 10% to 12% range, even if companies absorb 1 million sq. ft. annually for the next several years.

But despite the current conditions, industry veterans are comforted knowing this latest downturn is not nearly as dire as the one in the late 1980s, when rampant speculative building shot office vacancies to 30%, while landlords mortgaged themselves to the hilt with high-interest loans.

In addition, owners and brokers are convinced Phoenix's historic growth will eventually prevail. The region's population has increased by 54% since 1990, compared with the U.S. rate of 15%, according to demographic studies, and is projected to grow at more than twice the national rate for the next decade.

This year alone, the Valley of the Sun is expected to expand its 3.3 million population by 90,000 — much less than the 125,000 average annual population growth of the late 1990s, but still a pretty good clip, according to Pollack. “Everyone here knows that even if we push the vacancy up, it will get bailed out with growth,” says Tom Rex, research manager for the Center for Business Research at Arizona State University. “Sure, 20% vacancy may be cause for concern, but once the economy turns, we'll work through that vacancy a lot faster than other parts of the country.”

Scottsdale's Star Still Rising

Scottsdale, an upscale suburb of 215,000 people east of Phoenix, is still holding its own, however. The completion of the Loop 101 freeway cutting along the city's eastern edge has ignited a blaze of office growth in a submarket once considered remote. In the five years since freeway construction began, 55 new multi-tenant office buildings totaling 4.3 million sq. ft. have sprouted up in the city, causing some to wonder if it will elbow Phoenix aside as the Valley's future business hub.

In the last 90 days alone, developers have broken ground on nearly 500,000 sq. ft. of office product in an emerging business district near Scottsdale Airpark. Luke Walker, a vice president in CB Richard Ellis' Phoenix office, says Scottsdale's three submarkets totaling 11.5 million sq. ft. could surpass the Phoenix CBD's 15.1 million sq. ft. by 2006, making it the largest office core in metropolitan Phoenix.

The Phoenix CBD, which includes uptown and downtown, has been withering for years. Its vacancy rate in the second quarter was 20.5%, which reflects the five-year migration of tenants from Central Avenue to newer buildings in the suburbs or build-to-suits. The Arizona Department of Environmental Quality vacated 150,000 sq. ft. there last year. Scottsdale, on the other hand, absorbed a net 61,879 sq. ft., dropping from a 15.3% vacancy rate in 2002 to a 15.1% vacancy rate in the second quarter — one of the lowest of any submarket.

On the other hand, the metro Phoenix vacancy rate climbed to 19.4% from 17.9% a year ago, according to CBRE. “A lot of decision makers reside in Scottsdale and have realized they can work close to home while easily importing employees from surrounding cities via the freeway,” says CBRE's Walker.

Last year, San Francisco-based DHL international air express company leased 106,000 sq. ft. at Koll Perimeter Center in North Scottsdale for a data processing facility. In May, Wireless Retail, whose 74,000 sq. ft. headquarters are in Scottsdale, took an additional 90,000 sq. ft. for a call center.

The Alter Group, a Skokie, Ill.-based developer, recently announced plans to build a $400 million, 2.5 million sq. ft. office and retail complex adjacent to Scottsdale's Loop 101 on the Salt River Pima-Maricopa Indian Community early next year.

Kurt Rosene, senior vice president with the company's Phoenix office, says the overall market may be soft, but sites are scarce for users like Waste Management, American Express, Verizon and Washington Mutual, which have begun scouting again for large blocks of space. Rosene says he has spoken with more than 10 prospects, but as of August had not begun pre-leasing.

Other indicators also give investors hope that the worst is over. At approximately $22 per sq. ft., average Class-A rents remain virtually unchanged from the height of the last boom in 2000, and some of the newer buildings in Scottsdale are actually fetching as much as $29 to $32 per sq. ft., according to CBRE.

Multifamily Sector Still Smarting

Equilibrium is still several years away for the metro Phoenix apartment market, which has suffered because incredibly low interest rates have made home ownership so affordable.

Although home mortgage interest rates have risen from 4.9% to 5.67% for a 30-year loan over the past few months, it's not enough to make renters stay put, says real estate industry analyst Bob Kammrath of Kammrath & Associates in Phoenix. “If the trend continues, it will mean an incremental improvement in the apartment market,” he says. Meanwhile, landlords continue to lure tenants with deals ranging from $99 move-in specials to one month's free rent.

On the plus side, weak fundamentals haven't dampened investor interest. Properties changing hands may be smaller and older than before, but deal velocity remains brisk, according to Marcus & Millichap. The firm reports 100 sales worth $324 million this year as of June, compared with 97 sales and $368 million in volume during the same time last year.

“There's a huge demand out there,” says David Wetta, senior vice president and regional manager of Marcus & Millichap's Phoenix office. “Phoenix, compared to California or Colorado submarkets, offers a lot more units for the dollar and our job growth indicators look good for the future.” Roughly 27,000 new jobs, equaling 1.7% annualized growth, are anticipated for 2003, compared with a 0.7% increase in 2002, according to ASU's Center for Business Research.

Wetta predicts double-digit vacancies will drop from 11.44% to 9.5% by year's end. Average rents metro-wide will fall by 2%, to $680 per month.

A welcome construction slowdown means only 4,700 new apartments — a 25% drop from 2002 — will be delivered to Phoenix's 238,844-unit inventory this year, Wetta says. Topping the list is San Diego-based Fairmark Development's Sheely Farms, a 408-unit complex at 93rd Avenue and McDowell Road in Phoenix.

Retail Continues to Shine

Two major transactions rocked the retail sector this summer. In August, Taubman Centers Inc. sold the 40-year-old Biltmore Fashion Park — considered the grand dame of Phoenix retailing destinations — to The Macerich Co. for $158.5 million. Macerich, which functions as Westcor in Phoenix, also owns Scottsdale Fashion Square, which was Biltmore's biggest competitor. Westcor will manage both malls, which is expected to open numerous leasing opportunities for the two properties.

And this June, The Shops at Gainey Village, an upscale shopping center in Scottsdale built by Westcor, sold for $60.4 million to a group of private investors. At the time, it was the largest retail sale since Biltmore last changed hands in 1994.

Across the metro area, retail vacancy rates have held fairly constant at 7.22% over the past years, according to CBRE.

Much of the 3 million sq. ft. of space under construction involves grocery-anchored centers in high-growth residential areas. Approximately 25 new projects are due this year, consistent with the past eight years, according to Judi Butterworth of DeRito Partners, a Phoenix mall developer. “That may seem like a lot to many markets, but not many markets are growing like Phoenix,” she says.

On the non-grocery side, Phoenix's Vestar Development is planning four new power centers, totaling more than 4 million sq. ft. among Tempe, Gilbert and north Phoenix, by 2006. Kohl's, a newcomer to the market, will open 13 department stores this fall.

Industrial-Size Struggles

A few large lease transactions, including Progressive Insurance's 165,000 sq. ft. deal and Portola Packaging's 115,000 sq. ft. agreement, couldn't prevent the troubled industrial market's net absorption from slipping into the red for the first time in more than a decade. Phoenix experienced negative net absorption of 298,520 sq. ft. in the second quarter, according to CBRE.

A second-quarter bankruptcy filing by Dallas-based grocery wholesaler Fleming Cos., which dumped 1.5 million sq. ft. of warehouse space into a soft market, didn't help. Vacancies climbed to 10.92%, up from 10.32% a year ago. Fortunately, lease rates held steady from 2002 at $0.32 per sq. ft. for warehouse distribution space.

Despite the 3.1 million sq. ft. of new build-to-suit and spec product under construction, Pete Bolton, senior managing director of CBRE's Phoenix office, says selective building still makes sense. “Activity is just starting back up,” he says. “Once it's back, we could turn absorption around in six months to a year easily and in some submarkets be out of product.”

Alan Gillespie, vice president of the Phoenix office of general contractor McShane Corp., says the Chandler submarket southeast of Phoenix is ripe for the light industrial product many users want but can't find. The submarket's 5% to 6% vacancy rate motivated Chicago-based McShane to move ahead with a $50 million joint venture with MetLife. The first 200,000 sq. ft. is due in three buildings at Price and Frye roads next summer.

On the West side, Woodlands, Calif.- based Voit plans a fourth-quarter start on a 16-acre, multi-tenant project at 91st Avenue and Olive, near the Loop 101. Six buildings totaling 206,000 sq. ft. will seek light manufacturer and showroom warehouse users.

Healthy Hotels

Despite nearly 3,000 new rooms added to the market last year among three luxury hotels — The Westin Kierland, Sheraton Wild Horse Pass and J.W. Marriott at Desert Ridge — demand outpaced supply in the first half of the year. As of June, supply was up 4%, while demand increased 6.4% over the same period in 2002 based on number of room nights sold, according to Smith Travel Research.

According to Bobby Bowers, vice president of Henderson, Tenn.-based Smith Travel Research, Phoenix's numbers reflect an increase in leisure travel nationwide. The year-to-date figures received a boost from the inclusion of peak-season months January through March.

Overall, metro Phoenix's year-to-date occupancy at the end of June averaged 65.4%, compared with 63.9% in June 2002. Room rates averaged $103.89, down from $104.92 year over year and RevPar was $67.94, up from $66.66. National occupancy was 58.3% for the same period.

“That's pretty darn good,” says Bowers. “You can't find another market that's grown occupancy faster.”

Linda Obele is a Scottsdale, Ariz.-based writer.

PHOENIX - BY THE NUMBERS

POPULATION:

City: 1.4 million

Metro area: 3.3 million

UNEMPLOYMENT RATE: 5.5%

LARGEST PRIVATE EMPLOYERS:

  1. Wal-Mart Stores Inc. 15,895 employees

  2. Banner Health Systems 15,521 employees

  3. Honeywell International Inc. 15,000 employees



METRO AREA STATS

Office:

19.4% vacancy, 2Q 2003

17.9% vacancy, 2Q 2002

Rent per sq. ft.: $22 2Q 2003

Source: CBRE

Multifamily:

11.44% vacancy, 2Q 2003

11.26% vacancy, 2Q 2002

Rent per unit: $667.05 2Q 2003

Source: Marcus & Millichap

Retail:

7.22% vacancy, 2Q 2003

7.23% vacancy, 2Q 2002

Rent per sq. ft: $20 2Q 2003

Source: CBRE

Industrial:

10.92% vacancy, 2Q 2003

10.32% vacancy, 2Q 2002

Rent per sq. ft.: $0.32 2Q 2003

Source: CBRE

Hotel:

65.4% occupancy, YTD as of June 2003

63.1% occupancy, YTD as of June 2002

Source: Smith Travel Research

MAJOR PROJECTS UNDER CONSTRUCTION:

Opus Northsight Phase II, a 137,000 sq. ft. speculative Class-A office building at 87th Street and Loop 101 in Scottsdale, adjacent to the current Opus Northsight building

Cost: $25 million

Developer: Opus West

Completion: July 2004

Wells Fargo Bank Corporate Campus, Phase I, a 400,000 sq. ft. office complex at Price and Queen Creek roads in Chandler

Cost: $75 million

Developer: Wells Fargo

Completion: Late 2004

Sheely Farms, a 408-unit multifamily development at 93rd Avenue and McDowell Road in Phoenix

Developer: Fairmark Development LP of San Diego, Calif.

Completion: October 2003