Editor's Note: Like a lot of Northeastern cities, Philadelphia's commercial real estate market has had to fight back from the depths of the overbuilt recession of the late-1980s. Today it's 1996, and a lot has changed for the city, which is why we recently gathered some of Philadelphia's top real estate minds together in the 52nd-floor aerie of the Pyramid Club atop the Mellon Bank Center in downtown Philadelphia for lunch and a briefing on what's ahead for this dynamic market.
Q: How does today's market compare to the one of five years ago?
J. Richard Jones: The bottom of the market the way we measure it was '92 and '93. It started down in 1990, and hit bottom in '92. The difference now is there's a lot less space to lease than there was and rents are going up. Operating costs did continue to fumble along with a 2% to 4% increase. But the giveaways that were in the marketplace are coming out. And it's shifting from a tenant's market to an owner's market. That's definitely taking place in most every phase of our south Jersey suburbs and downtown. But the most dramatic change has been in the Pennsylvania suburbs, where there is single-digit vacancy out there. Tenants aren't getting the lower rents that they were getting and there is more balance coming into the market, slowly but surely
For sales, instead of getting 40% to 60% of book value, they are all moving up because there is demand for product by different institutions. The REITs have entered the market, as well as other private investors. There's this glimmer of light that says smart people are trying to buy, still below reproduction cost but not stealing them like they were back in the early-'90s.
Willard Rouse: Which is actually badfor some of us.
Kevin Donohoe: I agree with what Dick said. If you go back just 15 months ago, you were looking at buying leased suburban product for 75% of replacement cost. I think you're hard pressed to buy much below replacement cost. So the market's strengthened enormously in that area. The downtown is a different perspective. While downtown has improved, it sure has a long way to go. We've seen a reduction in giveaways but we're still seeing very low absolute rents in downtown office buildings, and certainly nothing approaching replacement value. The buildings are still trading at 40% to 50% of replacement value, which is better than a few years ago when they weren't trading at all.
There is bright news. If you look at the "A" space in the city, the user of a large contiguous block doesn't have much choice. So you are probably driving a betterto the large user downtown than the small user. The other thing we're seeing is that downtown offers real value, mostly because values moved up so greatly in the suburbs that it's almost a comparative issue. We see institutional movement back into the urban marketplace just because they're in a strong pursuit of value, and value is hard to get downtown today, whether it's on industrial sector or the office sector or the apartment sector, or anything else. The other great thing, and I hope this is real, there are an awful lot of people looking very hard at conversing space downtown into apartments.
If you do look at the apartment vacancies in downtown Philadelphia, it's a very low number. Some conversions will work and some may not.
Clive Mendelow: I agree with Dick and Kevin. Obviously the suburban market is excellent. The downtown market is stagnant. And the industrial market for distribution and warehouse is outstanding.
The Philadelphia market is a finite market. We haven't had a whole lot of new blood coming in. Definitely in 1985 to 1990, with the wave of new buildings it fed off itself again. One of the things we need to try to work out in terms of taking advantage of the fact that the world has become smaller and the country's become smaller and the region's be' come smaller in terms of communications technology and the difficult relationship of this city in the Mid-Atlantic, which has justified a lot of the industrial warehouse and distribution growth, I think we should try and turn those logistics somehow into an attraction for some of the office users as well. It seems to me that somehow or other Philadelphia is still a very good office buy compared to New York City. It's an excellent office buy. And it's an hour and 10 minutes away. We talked about this in the late'80s, but now we're at the point where we can actually demonstrate, because of the technology and communications and all the rest of it, that this is a viable place to be. I know there are some disadvantages, but we've got a lot of core, very good services here. I think that we can attract people now.
Q: Bill Rouse, you were instrumental in creating many of Philadelphia's Center City office towers. What's your take on how the area has changed in recent years? You've become an active developer in the suburbs ...
Willard Rouse: We've always been active in the suburbs. The lack of activity downtown is the vacuum that was created. I think the most significant change to the city is that it's more alive here at night than I've ever seen it. And it's not just one instance, it's all the time. I don't know quite what to attribute that to. Part of it may be the schools. Part of it may be the convention center. Part of it may be the hotel activity. Constantly I am surprised and taken aback by how busy the streets of Philadelphia are after seven o'clock. The number of people on the streets at night is amazing.
Q: Isn't Philadelphia a bit different from other major cities in that it already has a major residential and retail component?
Rouse: I think we've got an arm and a leg up on the new cities of America simply because of the residential component and the educational component. Our culture has not been dispersed quite the way it has with Dallas, Atlanta and places like that. It's still downtown. To me, those three legs of the stool are really crucial to urban America's future as a vibrant, successful place to be.
It's amazing to me the demographics. We're as busy as I've ever seen it in the suburbs. And yet job growth in Philadelphia is absolutely flat. I keep asking myself, 'Why all of this activity?' If the city is losing jobs, the fact of the matter is, the city historically has lost jobs to the suburbs. That doesn't answer all of the deals we're working on, because most of the things we're working on are increases in employment. Net job increases, not just obsolescence.
Mendelow: Is that existing companies or is that new blood coming in?
Rouse: Both. We've probably had $100 million to $150 million in build-to-suits made this year. These are huge, huge numbers.
Jim Kilgallon: Certainly as the skyline went up, we're coming out of the shadows of D.C. and New York. I look at the city from a different perspective from everyone in this room. I feel the city itself after 250 years is going through some different growing pains. A little thing like the Center City attitude is important.
Joseph Coradino: A couple of things are important to note. If you look at the suburban markets, the ones that are the most successful, they tend to be the markets that are closest to downtown Philadelphia. Which I think probably demonstrates the city's worth.
Look at Bala Cynwyd. In the most recent deal I've heard about, an all-in rate of $26.50 per foot for a building in Bala Cynwyd, for a 50,000 sq. ft. transaction. That's impressive. That deal obviously could have gone to any other market but chose Bala Cynwyd for the proximity to the city of Philadelphia.
The other thing is that when you start to see these kinds of rents, you start to also see the companies who went to the suburbs initially because they could realize certain efficiencies, can all of a sudden make a deal that's more favorable to their company by coming downtown. And probably the one thing that wasn't mentioned is the political administration in the city of Philadelphia right now. Which is very pro-business. I can remember one or two or three administrations back, if I had a 50,000 sq. ft. tenant and I placed a call to the city of Philadelphia I might not get a call back. And if I got a call back, it was certainly not a proactive approach. But I know now if I make a phone call and for a 2,500 sq. ft. tenant I can get somebody from the mayor's office to call that tenant directly.
Donohoe: You can get the mayor himself.
Coradino: We're really seeing a unified effort to attract businesses to downtown. Do we have a lot of success to point to to date? No, we really don't. But again, if you look at the indicators, if you look at the law firms in town, the accounting firms, they haven't chosen to leave the city, they aren't looking in the 'burbs. Their major presence still remains in downtown Philadelphia. It all has to do with the culture and the base of amenities the city provides.
Jones: One of the major issues we have to look at is what makes up the I tenant base in the suburbs versus the downtown. Philadelphia has suffered from the fortunate historical fact, that is the big space users in downtown have been the banks, insurance companies, large law firms and accounting firms, which if you look at the last four or five years, have been the industries that were the most aggressively downsized and consolidated - whereas the companies that you see growing are the technology firms, the pharmaceutical firms, the biotechnology firms, the information systems managers. So while there is good news happening downtown, we are confronted by the fact that the bulk of our space users have been in an industry-wide, nationwide, global-wide downsizing to be competitive. How do you replace that tenant base? Maybe the law firms start to grow again if business comes back. Maybe it's the health maintenance organizations. We've had some success leasing to them and they do grow. The issue is how do you get the growth-type company to this downtown or to any downtown.
Coradino: One of the answers to that question is incubation. The property owners in the city need to look at that market and understand it. It's high-risk, not a typical real estate deal. It doesn't even look like a real estate deal. You rent somebody a desk on a day-to-day basis. It's hard to finance that deal. That's where the new businesses come from, and I think some how some way, the city of Philadelphia has got to understand that and find a place for those businesses to grow, and then convince them not to go to Malvern.
Rouse: There goes my business! Let me give you one subtlety. There is an interesting thing going on in the suburbs. I spend a lot of time talking to tenants, and try to avoid the CEO-types and get to the office managers. The query is how can we be better landlords. If I can get people to say 'I'm in a Liberty building and i, don't want to move out,' then I've got a leg up on some of the competition. The thing that is most consistent is work interaction, employee-to-employee at different companies. What that's really saying is people act in social infrastructures, and there is a craving for it. When you get past the country club or the church, life in the suburbs is damned isolated, and people are beginning to express that. What they haven't come to closure on is where to get it.
The suburbs have the advantage of being quiet and tranquil and all that, but the average employee drives out of his one-acre lot isolated in his automobile, sees the same people at work, turns around, may or may not go out of his or her office to lunch and drives home at the end of the day. There's no interaction with different people, different cultures, different environments, different venues, etc. And they're beginning to express that.
Q: Will the landlords drive that interaction through new programs?
Rouse: We're aggregating a lot of space. You have the potential for creating huge platforms for interaction. Will it have the vitality and be more superficial than downtown? Yes it will be because you can't offer that diversity in the suburbs. It's people wanting to see other people whose business is different and not the same person you've seen in the last year.
You can do it geographically, with a 10K run, something with Christmas to involve as many companies as we can get involved. Creating the interaction through a superficial city isn't going to happen because Joe (Coradino) and I make a decision that it should happen. There's got to be a reason for it. When the city becomes perceived as a better mousetrap for that reason alone - social interaction - then it starts to reverse itself. That will draw people to the whole urban experience.
D'Alessio: I think we all fall in to the trap of dealing with the city versus the suburbs as if these were different economic entities. They're really not. There are political boundaries and we talk about the markets by dividing them by these boundaries, but that probably doesn't work in today's world. The city is changing, but it's evolving.
When I first came to Philadelphia 35 years ago, I worked on a project called Society Hill, which we had certified as meeting all of the federal requirements that you had to for one of the most blighted areas on the East Coast. Look at it today. There are 200,000 people living in Center City. That's more than when we started back 35 years ago. And it's changing. The population is becoming younger and more professional, and a better feeder for some of these smaller kinds of industries hat Joe referred to. Something like 60% of all the businesses registered in the city of Philadelphia have 10 or fewer employees. I think the center of the city is never going to be an increased office presence in the region. Maybe it's got to be smaller and more efficient. That's not a bad thing, it's part of the evolutionary process. Maybe some of those buildings can be used for residential development, for apartments and react to what the city seems to have become which is a great place to visit, a meeting location. As Bill said earlier, retail continues to be healthy, which is rare for a large Northeastern city.
Nobody's mentioned the waterfront yet. Our waterfront is much different from Boston's or Baltimore's and really doesn't really play as part of the actual core of the city. Nevertheless, if you really want to see people as compared to the convention center area just go down to the waterfront on a summer weekend and it's the meeting place for the region now.
D'Alessio: A recent study by the Philadelphia Federal Reserve which took all metropolitan areas of the United States, and they ranked the performance of the economies of the central cities and the suburbs. The one thing they found was there was no metropolitan area where the suburbs did well and the city died. Any region that was performing well had a relatively healthy Center City as part of the economy. Without it, it doesn't work. Everybody finds their place in the region's economy.
Jones: The regionalization of taxes would be something desirable. A lot of these people here have had a great impact on the city with their construction and their design and the space they've built because it's as good as any and better than most. When we talk to tenants about why they're leaving, there are reasons for concern. When you're downsizing you'll see a CEO or somebody from Out of town handling things, and it makes a difference where the person lives as to their commitment to the city. We've talked to people about the improved atmosphere of the Center City as compared to five or six years ago. It's dramatic. But there are things that have to be addressed. One is the taxation issue, and that's a very difficult one because there are very strong political implications there. The educational system needs and is getting a lot of attention. Those are critical issues, because the people who are moving their businesses aren't looking at the rent or at the operations cost to build. They're looking at the cost per employee. That transcends rent. It's benefits, it's health' care costs and then there's the wage tax, and the use and occupancy tax. If people can get more work per hour out of an employee in the suburbs, they'll pay more because they're getting more production per hour. If they don't have to take public transportation, they can take their car and get to work earlier and stay later. This has happened to a number of companies that have moved from downtown to the suburbs.
The city has advantages that the suburbs will never have, and vice versa. And Walter's right. we can't look at the individual pieces as much as we have to look at the collective whole and how each one fits into that collective whole.
I don't believe businesses will grow like they used to grow, where you'll be adding 50,000 people to the accounting firms. That's over and done with. Now, because people can move their operations centers to other states and other locales, they have different educational profiles for their employees, so the world of technology has changed the landscape that we're in, and therefore the solutions to the problems have got to be re-thought and looked at versus the '70s and '80s. That evolution is going to take a little longer than one might expect.
Mendelow: If we're talking about people moving from the city to the suburbs, we're still presupposing growth from the same group of tenants. The thing that puzzles me the most is how to attract new blood into the city. One of the advantages is where there's a non-emotional approach to a location, where you have a chief executive in Chicago making a decision about where to put his eastern or Mid-Atlantic division, it seems to me that's an advantage in the sense that he's not emotionally attached to any of the Mid-Atlantic states. If that's the case, then do we compare our Center City to the suburbs or to New York and Washington (D.C.) and Baltimore? That's one of the things we need to do, because we've always had a finite market here, a given number of companies with people who've grown and moved. How do we attract totally new people and organizations into the city? Is it done by comparisons to other cities in the region?
Rouse: I think the importation of jobs is a poor choice compared to the creation of new companies and the growth that follows them. If there's $100 million in venture capital funded for the city only, what will that spawn in terms of the biotech firms and other technologies that are evolving in this country? Silicon Valley exists because Hewlett-Packard and others started around Stanford, and a venture capital industry started to evolve in that area. There are venture capital firms that have never gone out of Silicon Valley. Some initiatives have to be revitalized and re-energized.
Donohoe: If you look at how much downsizing has occurred in the last few years, yet where are we now? We have net positive absorption downtown. Somebody's absorbing it. Look at your buildings. It's the 5,000 sq. ft. telemarketing firm that you put in your building two years ago that's now up to 20,000 sq. ft. It's the little data-processing firm for financial institutions that started at 7,000 sq. ft. and is now up to 25,000 sq. ft. It's the health maintenance organization that moved in with 25,000 sq. ft. and is now at 60,000 sq. ft. That's why we have positive absorption despite huge, overwhelming corporate downsizings. It's really a nice story.
Jones: We have a residential operation with 27 agents and we do over 20% of the downtown sales in condominiums and townhouses. When people come to Philadelphia to the suburbs to look for a home from the East Coast, they think that they're being shown the worst product because of the price. They say they can't believe the prices. They put money in their pocket when they come to Philadelphia. It's only going to be a matter of time until major corporations are going to see that this city that sits between Washington (D.C) and New York has economic factors that they can't ignore. They'll be suspect as a CEO if they ignore us.
D'Alessio: Back to the issue of growth, to attract international business is difficult. The decision usually boils down to the availability and productivity of the labor force. If you want to be competitive you've got to pay attention to that. You've got to make certain that at all levels of skill requirements you have adequate and productive people. If you go around and try to figure out where the administrative types and clerks and secretaries come from in our economy it's from those private and parochial school systems.
The real issue to me is if you could close the boundaries of the region and say nobody's allowed out, you'd probably choke on your growth. If you could view this region as a single entity and try to capture that increment, you would probably never have to bring somebody in from the outside to stimulate both tax and employment opportunities. The other point is that we're part of Pennsylvania, we're a big two-city state. It's hard to mount an identification campaign for the city of Philadelphia unless you do it on your own or from within, and that's a tough business. I'd much rather spend my time and resources trying to keep the folks that are here. They're here because it's a good area. These universities spin off a whole lot of investment opportunities for biomedical and technically related investment opportunities.
Q: Let's tackle the issue of information technology's impact on the local real estate industry and space utilization.
Rouse: I'm reminded of "smart buildings." It evolved from the technology to the simple statement that a smart building is one that is leased. While there are going to be technological changes and evolution of how space is used, other than vertical or horizontal issues within the core of the buildings, I don't think it's going to change a damn thing. The only thing that I would suggest is evolving is larger floor plates, which has a lot to do with the burgeoning industry of telemarketing and telecommunications, masses of people sitting at a computer with a phone communicating in some fashion, such as a catalog ordering business. The fear I have is what it's going to do to the retail business.
We keep talking about these changes, but hoteling is going to last how long? It will last until somebody says 'you know, this isn't really human. I car`'t put my stuffed toys in here. Where do I put the picture of my family? I'm not here as an animal or as a robot and sit in front of a CRT screen.' Technology that de-humanizes people will be rejected at some point in time as having gone too fat. As labor gets scarce, the work environment is going to be come one of the things that a potential employee looks at.
Donohoe: Flexibility is an issue. What you think you want today may be very much different a year from now, how you lay out your space. Look at some of your tenants and how rapidly they move space around. I think flexibility is the thing people want most. They also want power and lighting capability. We're inundated with issues of wiring. But basically a whole lot is not going to change, other than those issues of being able to have a product which is flexible.
D'Alessio: Not only do they want the technology, but they also want the best quality building they can get in appearance and location. Nobody's working out of their house. You still want to go to a place to work, and that place has to be high quality, easy to get to, attractively presented and that's inside and out.
Donahoe: High quality has a different definition today than it did five years ago. What we thought of as high quality five years ago as elegant, tall and lots of expensive materials is really the anathema for many tenants today. Some tenants will tell you they will not go in a building that looks like that. Efficient and highly productive space is important.
Rouse: What goes around comes around. I don't exclude the fact that we're in a cycle. We're seeing small companies go from 10 to six and now back to 12 employees, literally in a period of less than' four years.
Coradino: The problem all of us have is that the cycles are so much faster now.
Rouse: They're higher and lower.
Coradino: One of the things we've missed by not dealing with technology in the long term is the square foot per person in the workforce has decreased dramatically, and it has affected our business.
Rouse: It will be driven by efficiency and economy. U.S. industry got a wake-up call in this past recession, the realization that you've got to downsize to be competitive on a global basis. But now what you'll see as the cycle starts heading back up, companies will start putting on more people and the fat will reappear. It's inevitable.
Coradino: If we can only wait that long!
Jones I think hoteling was way overdone. Very little of it is taking place in the newer, well-designed offices. Bill's right, the floors are getting bigger because of technology. And you can't disconnect all of these people and put them in their cars.
Rouse: Where's the corporate culture? Is there a culture?
Mendelow: The large international corporations are looking at their work-place strategies in terms of size and efficiency. In addition, they are trying to standardize the nature of space allocation. As far as hoteling is concerned, the corporate anonymity is one of the biggest issues, and they are trying to compensate for that by creating clubhouses for people to come in and meet. But that's only good for certain companies.
Rouse: If you look sociologically at this whole issue of working at home, people need change, both of physical environment they need physical interaction with other people. Aside from the economic issues, one of the reasons we've seen an increase of women in the workforce is the need for interaction. Those who chose to raise families are now saying they need more from life than raising children 12 to 15 hours a day. They need to see other adults and they need other endeavors.
What we're seeing is driven by economies. Every expenditure was looked at, every dollar was being saved, and as time goes on, the cycle will change and people will being to realize that it takes more than a measurement of 150 sq. ft. per person.
D'Alessio: This has also come at the same time when people are incredibly more productive today because they have so much more support to do it with. Some of the limitations of technology are leveling out now. If you talk to kids coming out of college, none of them want to work in their home, none of them want to be call-in employees.
Joseph F. Coradino Executive Vice President The Rubin Organization
Walter D'Alessio President & CEO Legg Mason Real Estate Services
Kevin Donahoe President Kevin F. Donohoe Co.
J. Richard Jones President & CEO Jackson-Cross*ONCOR
Jim Kilgallon Vice President Commonwealth Land Title
Clive Mendelow President Binswanger Advisory Group
Willard G. Rouse III CEO Liberty Property Trust