Pulling itself out of the oversupply nightmare of the '80s, the office market is finally having sweet dreams about its future. Real estate professionals are sleeping a little better now that supply and demand are beginning to balance out.
If anyone needs a lesson in supply and demand economics, they need not look any further than the office market. The economics of no new supply and rising demand are combining to reduce, dramatically in some markets, the oversupply of office space across the country.
From 1993 to the end of 1995, just 13 million sq. ft. of new office space was delivered to the U.S. market. By comparison, 185 million sq. ft. were built in 1985 alone. Meanwhile, the economy has produced 8.7 million jobs since the end of the recession in 1992. Even though Corporate America continues to rightsize, emerging high-tech and corporate services firms are fueling the national job market.
"This is a recovery that's three years in the making," says Raymond G. Torto, a principal of CB Commercial/Wheaton Research, a Boston-based division of CB Commercial.
The nation's vacancy rate continued to improve last year, dropping 1.4 percentage points to 13.8% overall. And the tightening continued into the first quarter of this year, when availabilities in suburban markets fell to 15.1% from 16.6% a year earlier and 16.1% from 16.8% in downtown.
"All office markets are coming back because there's been a significant improvement in fundamentals," says Ray H. D'Ardenne, executive vice president of Atlanta-based Equitable Real Estate Investment Management Inc.
Net absorption totaled a positive 30 million sq. ft. at year-end 1995, up 2 million from the previous year, according to New York-based Cushman & Wakefield Inc. The healthy absorption has pushed rents up an average of 6.2%, CB Commercial says, with several suburban markets reporting increases of more than 10%. The firm forecasts overall double-digit rent increases for the country in 1996 and 1997 because supply will remain in check.
Last year new office construction totaled about 5.2 million sq. ft., including about 3.5 million sq. ft. of build-to-suit projects. This year, developers will build about 10 million sq. ft., with about 80% of the new construction in the suburbs.
The development is being pursued and completed by a group of well-known national and regional players, unlike the long list of characters that participated in the 1980s. "There won't be guys with pickup trucks building 200,000 sq. ft. projects," says Steve Jaggard, president and CEO of ONCOR International, Houston.
Despite the increase in activity, construction levels are still very low, which is allowing markets to recover further, says Bob Bach, national market research analyst at Grubb & Ellis. "With the economic recovery getting long in the tooth, the market is getting to the point where there will be some spec development," he says.
New construction primarily will take place in the nation's strong suburban markets of Atlanta, Boston, Dallas, Houston, Los Angeles, Seattle and Washington, D.C. "The suburbs are where we see the highest level of absorption and leasing because they offer lower operating costs, parking and access to good labor markets," says Maria Sicola, director of research services at Cushman & Wakefield.
Investors recognized the strength of suburban office properties last year. There's a flood of capital in the market, which has driven prices up as much as 20% to near replacement costs in a few markets.
"We're bullish on the office market," says David Latvaaho, president of leasing for Chicago-based Heitman Properties, which manages and leases a 200 million sq. ft. portfolio. "We see single-digit vacancies in most markets by year end and further rent spikes that will follow."
There will be a true supply and demand relationship in the next few years, says Rick Bradshaw, principal and national director of business development and operations in the Atlanta office of Prentiss Properties. "But there's some concern about the amount of money that's chasing the sector."
Capital floods sector
When the returns in the multifamily and industrial sectors began to dwindle, investors began flocking to the office sector. Pension funds, REITs, private investors and opportunity funds are flooding the office sector with capital, primarily chasing suburban office buildings.
"Real estate fundamentals clearly have improved," says Steve DeNardo, president of Stamford, Conn.-based ARES Realty Capital. "The speed of the sector's recovery is due to how much capital flows to the market and how quickly it is flowing." Investors typically are buying office properties at prices that are 70% of replacement value at modest cash-on-cash returns between 8% and 9%. Long-term yields, or internal rates of return, generally are in the 12% to 13% range. Investors anticipate generating more cashflow as leases roll over and rental rates rise.
But prices of suburban office properties, which have increased 10% to 20% in the last year, are reducing cap rates in the most attractive suburban markets.
"Capital is more aggressive and has pushed cap rates down 50 basis points since the beginning of the year," says D'Ardenne.
Earlier in the year, Atlanta-based Equitable Real Estate closed on the purchase of three major suburban office properties. In Somerset County, N.J., the firm acquired a four-building, 197,000 sq. ft. project on behalf of a pension fund client for $27.5 million. The seven-year-old project is 97% leased to three tenants. Equitable also bought a five-building, 317,000 sq. ft. complex called Hyatt Deerfield Office Campus in suburban Chicago for $22 million. Another suburban Chicago property, the 386,000 sq. ft. Oak Brook Regency Tower, was purchased for $18 million by Equitable's Value Enhancement Fund.
Foreign investors also are interested in suburban product. P.P.M. America Inc., the investment arm of Prudential of the United Kingdom, the largest life insurance company in England, acquired a 305,000 sq. ft. suburban Atlanta office building for $32 million. The 86% leased Platinum Tower was bought from Skanska U.S.A.
Other institutional deals include L&B Real Estate Counsel's acquisition of One Biscayne Tower in downtown Miami. The deal was the largest in metropolitan Miami last year. The firm paid just under $100 million for the 620,000 sq. ft. tower, which is 95% leased.
"It's a stable, well-leased property in a market we like," says Daniel L. Plumlee, executive vice president and COO of The L&B Group. "There are well-located, well-leased properties still available at prices below replacement values in most markets we follow."
Now, however, investors say internal rates of return of less than 11% accompany many winning bids.
"Returns are getting pretty low when you take into consideration all the capital expenditures and improvements the assets require," says Dale Taysom, managing director of Atlanta-based Prudential Real Estate Investments. "Suburban office buildings are at the top of everyone's list, which makes investing (at an acceptable yield) a little difficult."
While the relative stability of suburban properties continues to whet the appetite of investors, a growing, and diverse, number of buyers are looking at central business districts again. Most sought after, however, are the half-dozen or so 24-hour cities. Atop most lists are Boston, Chicago, Miami, midtown New York, San Francisco and Washington, D.C.
"Opportunity funds and even institutional investors are poking around some downtowns," says Bach. "It's a weird mix, but a welcome mix."
Prudential Real Estate Investors invested in the Boston area, acquiring One Memorial Drive in Cambridge, Mass., for more than $50 million. And Taysom likes downtown Portland, Ore., a secondary city with a vacancy rate of 8.2% and an emphasis on public transportation and infill residential development as well as Salt Lake City, with a 6.2% vacancy rate.
Yarmouth Capital Partners LP I, a fund managed by Chicago-based Yarmouth Group, acquired the 32-story CNG Tower in downtown Pittsburgh late last year. The purchase includes an adjacent parcel with a development potential of another 622,000 sq. ft. The property was bought from an entity controlled by Kemper Investors Life Insurance Co.
Chicago-based Equity Office Holdings continued its opportunistic investment strategy on behalf of the Zell/Merrill Lynch funds earlier this year by acquiring 1601 Market Street in downtown Philadelphia. The 681,000 sq. ft. building, the firm's first investment in greater Philadelphia, was acquired from the Prudential Insurance Co. of America. The structure was 80% leased at closing.
Average Class-A rents in the first quarter in downtown were $19.16 per sq. ft., says New York-based Julien J. Studley Inc. The firm also pegged Class-A vacancies at 6.7%, with occupancies in the CBD's five best properties at the highest level of the decade.
"All markets are firing up, with rents jumping at nearly double-digits," says E. Valjean Wheeler, COO of Equity Office, which leases and manages 30 million sq. ft. "But, with the amount of capital from private investors, REITs and other opportunity funds chasing product today, there's a risk of paying too much for an asset."
To date, three Zell/Merrill Lynch funds have acquired a portfolio of $1.6 billion in U.S. real estate. Earlier this year, the group increased its holdings in Austin, Texas, to 1.5 million sq. ft. by acquiring the 505,000 sq. ft. One American Center. Its Austin portfolio is 90% leased.
A fourth Zell/Merrill Lynch fund will close soon, creating an additional $600 million in investment capital.
While CBDs will do better tomorrow than today, "the suburbs will always out-do them because the suburbs have enormous labor costs advantages and lower commuting times," says CB Commercial's Torto.
In an increasing number of suburban and downtown markets, companies with large space requirements will have trouble finding space. And the firms that last signed deals in the recession could see their rent double.
"Other than two or three CBDs, the office market trends are very positive," says Gary Beban, president of CB Commercial Real Estate Group. "Fortunately, we still have limited construction, and we've had greater than anticipated demand from new companies."
"The worm has turned, and the window is closing quickly," Beban says. "If a client's core business is growing, we're advising them that now is the time to extend or move."
"There's sticker shock because it was such a tenant's market," adds Prentiss' Bradshaw. "But that market is over for the foreseeable future."
Prentiss Properties recently hosted a workshop in which 30 corporations outlined their real estate needs. The flexibility of the space was among the most important factors. Rather than flashy specialty space with plenty of private offices, users want efficient space that can be retrofitted easily to accommodate different work stations and technology requirements.
Two other top site factors are convenience and safety -- factors that, along with bottom line considerations, point to the suburbs. And, in some markets like Chicago, Dallas and Houston, the appeal persists even though the difference between suburban and CBD rents is virtually negligible.
As a result, owners are proposing spec suburban developments that are smaller than the 1980s' buildings and contain more parking spaces and less granite and mahogany.
The vitality of the suburbs is evident in all corners of the country, particularly in the growing number of markets where developers are contemplating new development.
Dallas-based Trammell Crow Co. plans to build up to six new office projects in suburban Dallas. The firm is preleasing several buildings in the near north suburbs, including a 190,000 sq. ft. building and a 150,000 sq. ft. facility. It also has two sites in Las Colinas, an established submarket that contains 8 million sq. ft.
(1) Ranking is based on qualitative analysis of vacancy rates, forecast value change, years to balance, FIRE and Services Employment growth by percentage and absolute change.
"There's been strong absorption in suburban Dallas the last couple of years," says Chuck Anderson, executive vice president of Trammell Crow, "and we expect absorption to continue this year and into 1997."
Rents in the Dallas suburbs are about $21 per sq. ft, close to replacement costs of $25 per sq. ft.
In suburban Boston, where the vacancy rate dropped two percentage points to 9.4% at the end of the first quarter from a year earlier, Leggat McCall Properties Management has fully leased a building it redeveloped on spec. Molten Metal Technology Inc. committed to the 77,000 sq. ft. facility in Waltham, Mass., in April. The firm is paying about $23 per sq. ft. gross. Operating expenses at the park are about $6.50 per sq. ft. Leggat McCall plans to start work on the redevelopment of another building in the park this month.
"Technology firms are one of the engines of growth in the Boston area," says Mahmood Malihi, president of Leggat McCall Properties Management. "In both the suburbs and the CBD, there's a diverse base of companies that are the engines of the economy."
In suburban Chicago, Westchester, Ill.-based Podolsky and Associates finished construction on a 221,000 sq. ft. spec building in its Westbrook Corporate Center that is about 65% leased. The project is the suburb's first spec office building in more than four years. And Minneapolis-based Opus North Corp. hopes to break ground on a 250,000 sq. ft., seven-story spec office building in the same submarket, which has an overall vacancy rate of 9.9% and just 7% for Class-A space. Rents, meanwhile, have risen 8% to 10% to as high as $19 per sq. ft.
"The suburban office market is the tightest it's been in more than a decade," says Marilyn Lissner, a director in the Rosemont, Ill., office of Cushman & Wakefield. And Jeff Barrett, the director of the firm's Schaumburg office, says the vacancy rate will fall into the single-digits by the year's end. He predicts that net absorption will tail off to about 2 million sq. ft., only because a lack of available space will curtail expansion.
In Edina, a southwestern suburb of Minneapolis/St. Paul, Minneapolis-based United Properties is riding a 20% to 25% jump in rents to develop a 1.2 million sq. ft. business park. The first phase of the park will consist of a six-story, 130,000 sq. ft. building.
Brian Carey, project developer for United Properties, says construction will start when about one-third of the building is preleased. Asking rents will be $15 to $17 per sq. ft. net. The building will contain 24,000 sq. ft., rectangular floor plates.
"Rates and occupancies have risen dramatically," Carey says, adding that the 12 million sq. ft. submarket has an overall vacancy rate of 4%. "There's a strong economic climate here now."
Indianapolis-based Duke Realty Investments Inc. started work on a 154,000 sq. ft. spec building in Columbus, Ohio, earlier this year. The building will increase Duke Realty's office portfolio in suburban Columbus to about 1.3 million sq. ft.
Much of the building activity in Phoenix is what locals call back-room office. Developers are constructing spec one-story, multitenant facilities that range from 60,000 to 120,000 sq. ft., particularly in the Southeast Valley in Tempe, Ariz., and the airport area in central Phoenix.
"It's the latest craze," David Krumweidi, senior director of development for Opus Southwest, the Phoenix office of Minneapolis-based Opus Corp., says of the trend to build back-room office, which is called back office and flex space in other parts of the country. "Developers are signing tenants that are locating call centers and credit card processing uses in the facilities."
The rents are as high as $14 per sq. ft. gross., which some tenants consider a value since parking is free.
In Atlanta, absorption has pushed the metro area's vacancy rate to below 10% for first time in modern history, which has spurred spec construction. And Philadelphia's suburban market is firming to the point that developers are exploring spec development. "There will be projects announced in the suburbs by year end," says Joseph F. Coradino, executive vice president at The Rubin Organization Inc., a Philadelphia-based full service real estate firm that manages and leases about 6 million sq. ft. a year. "There's demand for new space by some sizable users."
The vacancy rate in the Philadelphia suburbs, which stands at about 15%, could dip into the single-digits by the year's end. Rents are up about 10% to as much as $26 per sq. ft. gross, particularly in submarkets like Berwyn.
A shortage of quality space also is spurring development in some downtown markets. With two Philadelphia-area space requirements totaling 500,000 sq. ft., PNC Bank Corp. opted to lease space downtown and build a new facility in an infill location. PNC committed to 300,000 sq. ft. at 1600 Market Street, a building owned by the Yarmouth Co., for a regional headquarters, and signed a long-term, 377,000 sq. ft. for a facility that will house an operations center. The building will be delivered next year.
"There's still excess in the Philadelphia market, but there's been no new supply for years," says John Powers, an executive managing director with New York-based Edward S. Gordon Co., which represented PNC Bank in both transactions. "Increasingly, firms won't be able to satisfy their requirements in the space that exists in the market."
David Elovitz, vice president of New York-based Park Tower Realty, says the midtown Manhattan market in New York is tight for both large and small users. "It's getting harder and harder for tenants with requirements as little as 10,000 to 30,000 sq. ft.," he says.
Rental rates are as high as $44.40 per sq. ft., according to Edward S. Gordon. The rates are not high enough to support new construction, but a couple of sites are in play for spec development. One is a prime midtown site on Madison Avenue that was acquired by the AlBabtain family of New York from a partnership controlled by CS First Boston and The Ronson Organization.
Thanks to a property tax incentive, construction on the first new Class-A office in New York in seven years will begin later this year. New York-based Durst Organization will develop a 1.5 million sq. ft. tower in Times Square that will be anchored by Conde Naste Publishing. Occupancy is scheduled for the summer of 1999.
"Because of the tax treatment, our rents are not significantly higher than other Class-A buildings," says Douglas Durst, president of the Durst Organization, which owns 4.5 million sq. ft. in midtown Manhattan. "But we'll have a new building so we have an advantage."
The building will lease for about $45 per sq. ft. New buildings with no subsidy would require rents at least in the low $50 per sq. ft. range.
Hines, the Houston-based developer that tapped foreign markets when the market cooled here, started work on its first U.S. project since the recession in Washington, D.C. In a joint venture with one of its financiers, DIFA Deutsche Immobilien Fonds AG of Hamburg, Germany, Hines is developing a 240,000 sq. ft. building that will be anchored by the law firm of McDermott, Will & Emery.
"There still is tenant growth in Washington, D.C., and rents are rising," says Hines' spokesperson Ann Kifer.
Believing that development opportunities in the suburbs of Phoenix may have peaked, Opus Southwest is turning its attention downtown again.
"We're at the starting point for Class-A office in Phoenix," says Opus. The firm, in a joint venture with Scottsdale, Ariz.-based Globe Corp., broke ground on the Class-A space in the greater Phoenix market since 1991. The first phase of the $45 million Scottsdale Spectrum project will include twin 57,000 sq. ft. buildings. It was 40% preleased when construction started earlier this year and is now 50% committed. Completion is set for this year.
The second phase will include a three-story, 136,000 sq. ft. building. The project also will include 1,000 below-ground and surface parking spaces.
The vacancy rate in Scottsdale fell to 5.25% at year-end 1995 from 7.6% at year-end 1994, according to Lee & Associates. The rate was 23% in 1992. In Phoenix, the overall vacancy rates remained a high 23% in the first quarter, but the rate for Class-A space was 9.7%, down from 17% in 1992.
Efforts are under way to diversify downtown Phoenix and create the 24-hour city that appeals to investors and tenants. Construction is under way on a $280 million baseball stadium for a major league expansion team, a Broadway-style theater and cultural attractions like a science museum and an expanded art museum. In fact, public and private investment in downtown since 1991 is estimated at almost $1 billion.
With the exception of Chicago, Houston, Los Angeles, Philadelphia and downtown New York, rents in major CBD markets have risen.
Whether the tightness of the suburban markets will renew interest in the country's forgotten CBDs remains unclear. Perhaps the most telling battlefields include two Texas markets. Dallas' downtown vacancy rate of 36.7% was the highest of major metro areas at the end of the first quarter. While downtown has been clobbered by the failure of financial and energy industries, the suburbs have attracted new industry at premium rents. At the end of the first quarter, suburban rents were $17.81 per sq. ft. compared to $16.50 per sq. ft. downtown, according to Cushman & Wakefield. And leasing jumped 42% over last year to 2.7 million sq. ft. Even though the suburban vacancy rate stood at a moderately healthy rate of 13.2%, developers are shopping new projects.
"Don't count downtown out," says Anderson of Trammell Crow Co. "Some firms will chase economics."
In Austin, the vacancy rate downtown was 19.3% while just 7.6% in the suburbs. "High-tech companies like Intel are outstripping supply," says CB's Torto. "Downtown's the only alternative for some tenants."
A similar dichotomy exists in Los Angeles. The vacancy rate downtown remained a high 21.6% in the first quarter, while the major suburban markets posted rates as low as 11.2%, according to Julien J. Studley. Developers are busy preparing new suburban sites. For instance, Los Angeles-based K. Young Development Inc. is building the 500,000 sq. ft. World Paladium Tower in Glendale, Calif. Delivery is scheduled for early 1998. The firm, the U.S. arm of a Korean construction company, will target entertainment tenants.
"The differential between suburban and CBD rents is so great in some markets that CBDs are retaining firms and making suburban firms consider in-town locations," says Beban.
In Houston, for example, a downtown deal was completed in the beginning of the year with a suburban firm. M-1 Drilling committed to a 90,000 sq. ft., 11-year downtown deal from the suburban Greenway Plaza market. And Houston-based Continental Airlines reportedly is considering downtown for a 300,000 sq. ft. consolidation requirement.
Rents downtown, which is still saddled with a high 20% vacancy rate, are down more than $2 per sq. ft. from last year to $14.27, which is slightly more than $13.90 per sq. ft. that owners are asking for in the suburbs, according to Julien J. Studley Inc.
In-town markets also are attracting build-to-suit and spec development. Equitable topped off Monarch Tower last month in Atlanta's Buckhead area. The 575,000 sq. ft. building is at least 50% preleased. Equitable will house its international headquarters in 175,000 sq. ft. Completion is set for January.
Financing remains tough
New construction on a spec basis is reappearing slowly, says Heitman's Latvaaho. "The development will be back to basics (in terms of satisfying actual demand), and they won't be over-financed."
Lenders are developing an appetite for office properties but, unlike the 1980s, they require equity participation of 25% to 30% and at least 50% preleasing.
With these two requirements, developers could possibly attract construction financing from one of the handful of banks still willing to lend on new office projects.
"Over the next year, we'll see selective office buildings built," says Robert Greer, senior director of Cushman & Wakefield Inc., who identifies financing sources for owners. "But it's likely that the banks will require a take out to write a loan."
With rents expected to spike, developers are trying to convince financial sources to reduce their preleasing requirements by half.
"If too much preleasing is required in this market, the ones who win are tenants," says Jim Ventura, senior vice president of Carey Winston Inc., a Chevy Chase, Md.-based mortgage company that is working on financing packages for two major spec projects. "Tenants could take 20% of a project's profit margin by signing at discounted rents."
As long as banks remain cautious and Corporate America stays cost conscious about its real estate usage, development should remain in check through the remainder of the decade. And limited supply equals continued improvement for all office building owners and investors.
"I think we're on a run for several healthy years," says D'Ardenne.
Even though the sector appears on its way to equilibrium, brokers and investors say a spate of new development could throw the recovery off track.
"Now we'll see how disciplined the industry will be in meeting the demand." says Beban.