Hill International Real Estate Partners' president Garrett Miller breathed a heavy sigh of relief as the Philadelphia City Council approved his request to build the second-tallest building in the country in downtown Center City.

Sound like a flashback to 1986 at the height of America's commercial real estate boom? Hardly, it was Dec. 11, 2008, at the deep end of arguably the worst recession to hit since the Great Depression.

Hill's proposed American Commerce Center at 18th and Arch streets would be the most visible symbol of Philadelphia's intent to enter the business big leagues. Designed by New York architectural firm Kohn Pederson Fox, the center would stand 1,510 feet high and encompass some 2.2 million sq. ft. of office space and a hotel. For perspective, it would climb 975 ft. higher than the city's newest tower, the 57-story Comcast Center next door.

Miller knows a thing or two about winning. He is a three-time world and Olympic rowing champion, and has been involved in more than $250 million in local real estate ventures since 2006. In downtown Philadelphia, he helped revitalize two of the city's historic landmarks — The Curtis Center and The Public Ledger Building.

But his new project will test even his strong resolve. In October 2007, Miller purchased what for 30 years had been one of downtown's largest surface parking lots, and he has spent an estimated $2 million on the marketing program and architectural aspects alone.

But given the severity of the credit crisis and lack of construction financing, funding for the project remains a mystery. Even without a lead tenant, Miller says he plans to break ground later this year, with completion as early as 2013.

There is one bit of good news in Miller's favor — he knows there is only one block of trophy office space of 100,000 sq. ft. or more available in downtown Philadelphia, and he hopes to lure a corporate user from nearby New York or Washington, D.C.

The striking project would be an anomaly in the city. “It's a very conservative market where bold moves are rarely taken,” says Dan Dagit, senior vice president in CB Richard Ellis' suburban Philadelphia office.

“The difference in Philadelphia is that our booms are lower and our busts are shallower, so when everybody is building like crazy we're not, and when everybody else is suffering a lot, we're only suffering a little because we didn't have as good of a party,” he says.

According to real estate services firm Marcus & Millichap, developers expected to bring 1.7 million sq. ft. of new office space to Philly's market by the close of 2008. By comparison, in Phoenix, the nation's fifth-largest city, developers expected to deliver 2.5 million sq. ft., a 4% increase over the existing supply. Philly's new 1.7 million sq. ft. amounts to just 1.7% of existing supply.

Local jobs on the wane

Philadelphia's jobs picture, however, looks far bleaker than the office market statistics suggest. The Pennsylvania Department of Labor and Industry reported the area's jobless rate rose three-tenths of a percentage in October 2008 to 5.9% percent, up from 4.3% a year earlier. The statistics cover the area of southeastern Pennsylvania, southern New Jersey and parts of Delaware and northern Maryland. In the city of Philadelphia, the October jobless rate rose two-tenths of a percentage point to 7.7%.

Local economists are unsure how the national jobless rate will affect Philadelphia. Of the 533,000 jobs lost nationwide in November 2008, the sector losing the most workers — 136,000 — was professional and business services, a staple of most American downtowns. In the decade from October 1998 to October 2008, that sector in Philadelphia and its four suburban counties grew 14% from 266,300 to 309,800.

Bolstered by its big employment sectors in education, thanks to the University of Pennsylvania, Temple University and 60 other colleges, as well as a concentration in health services, the region may fare better than many, as “eds and meds” are less prone to shedding jobs than other sectors, notes Steven Wray, executive director of the Economy League of Greater Philadelphia.

However, the local “meds” industry could endure some stressful times. London-based pharmaceutical firm GlaxoSmithKline announced in November it would consolidate its two headquarters, one of which is in Philadelphia, into one operation in Research Triangle Park in North Carolina. Glaxo employs 4,500 in the Philadelphia area, 1,500 in Center City and 3,000 in the western suburbs. It is still unclear how many, if any, local jobs will be affected.

Drug maker Merck & Co., which employs 12,500 workers in the Philadelphia area, announced it is laying off 2,700 employees across the U.S., but has yet to announce how many of those layoffs will occur in Pennsylvania.

Fiscal crisis mounts

Certainly the national economic crisis is putting pressure on Philadelphia. Declining revenues from business and real estate taxes are squeezing the city's finances. Lower-than-expected returns to the city's pension fund siphoned off $4 million in cash earmarked for other city services.

Philadelphia is enduring its worst fiscal crisis since 1991. While the city started 2008 with a $119 million budget surplus, by November its $4 billion budget was expected to see a $108 million deficit over the next six months, and a forecast deficit topping $1 billion over the next five years.

Mayor Michael Nutter's response was sharp — close libraries and swimming pools, suspend planned tax reductions until 2015, cut more than 800 jobs and trim salaries of some of the city's 23,000 employees. Nutter cut his own $186,040 salary by 10% on Jan. 1, 2009. “Painful program and service cuts are necessary,” he said in a televised address.

Downtown tenants on hold

Before the worst of the credit crisis, Philadelphia's comparatively low office rents made it an attractive alternative for many corporate tenants in nearby New York City and Washington, D.C.

“One of the goals of American Commerce Center clearly was to draw tenants in from the international community in New York or abroad,” says Michael McCurdy, managing director and president of Jones Lang LaSalle's Philadelphia office. The idea was to create more of an international city in Philadelphia. “But there are a lot of things that have to happen to make that work. We can leverage from other markets, but we've really got to grow from within Philadelphia.”

The University of Pennsylvania's “Penn Connects” master plan was designed to do just that. The plan was to connect the eastern edge of the campus across the Schuylkill River to West Philadelphia. But late last year, one key component stalled.

Blackrock Inc., a New York-based international money manager, was rumored to be moving its New Jersey operations to a new building called Cira Centre South near the university, but the deal fell through after the credit crunch hit in October 2008.

The developer, Brandywine Realty Trust based in Radnor, Pa., is proceeding with other aspects of the $800 million development. For one thing, Brandywine is working on a parking garage at the site, and it is renovating the U.S. Postal Service building to accommodate the local office of the Internal Revenue Service in a 700,000 sq. ft. lease.

Meanwhile, the downtown market saw the delivery of the city's tallest office tower in 2008, the 1.2 million sq. ft. Comcast Center. Comcast has leased 90% of the building.

In 2005, the 28-story Cira Centre, then Philadelphia's tallest office building outside Center City, was completed on the western side of the Schuylkill River next to the 30th Street station. The Cira building is now more than 90% leased.

McCurdy notes that both buildings reflect the tight downtown office market, which has less than 10% vacancy. “When there is a large user in the marketplace there is really nowhere to go in Center City.” That's why another new tower could provide space for a large user that needs to relocate from its existing location.

Overall, tenants are taking a wait- -and-see approach to changing economic conditions and a deteriorating office market. According to Cushman & Wakefield, the downtown office market showed negative absorption of 458,000 sq. ft. for the first three quarters of 2008 compared with positive absorption of 2 million sq. ft. for all of 2007.

“Right now we're seeing a lot of tenants decide to wait, watch, and try to take shorter-term renewals and ride this out until they understand what's going on,” says Mitch Marcus, first vice president in CB Richard Ellis' downtown Philadelphia office.

“We know the investment banking industry in New York is really going to take its toll there, but we have a diversified base,” adds Marcus. Investment banking firms set up local satellites of their major offices, he says, so New York's quick fallout of sublease space and tenancy is less of a problem.

Suburban office: signs of health

Though barriers to building are few, suburban Philadelphia's 58 million sq. ft. office market posted a healthy vacancy rate of 12.68% at the end of the third quarter of 2008, according to CB Richard Ellis, down from 15.26% at year-end 2007. The largest suburban market, King of Prussia/Valley Forge, posted a 12.97% vacancy rate at the end of the third quarter.

Sales transactions have been few, but that did not prevent one of the highest profile sales in recent years. In October 2008, KBS Real Estate Investment Trust purchased Five Tower Bridge, a 223,700 sq. ft. trophy office property in West Conshohocken, Pa., for $73 million.

The seller was a partnership of Brandywine Realty Trust, Cornerstone Real Estate Advisors and Oliver Tyrone Pulver Corp.

Still, the national economic chill appears to be taking hold. “The year came in like a lion and went out like a lamb, unfortunately,” notes Dagit. “The leasing activity has gone from strong to moderate, and concessions are increasing, mostly in the form of free rent.”

As with the downtown market, suburban tenants are taking a wait-and-see approach with space decisions, many choosing to remain in place thanks to murky 2009 budget forecasts. According to Cushman & Wakefield, suburban absorption tallied negative 38,000 sq. ft. through the first three quarters of 2008 compared with a total of 1.2 million sq. ft. absorbed in all of 2007.

In lieu of new construction, many older buildings of 1970s and 1980s vintage are being repositioned as new product for tenants. “We haven't had any distress,” says Dagit. “But we have had old and tired buildings that need to be upgraded. They're well located and once they get a facelift they lease right up.”

As harsher economic realities take hold, tenants are drawn to the new space at cheaper rents. “The rental rates for Class-A space right now are in the high $20s, about 25% short of what you need for new construction,” Dagit says. As a result, buildings are being repositioned and they are renting in the mid-$20s. Tenants are unwilling to pay $35 or $40 for new space, but they're happy to pay rents in the mid-$20s, he adds.

Investors will closely monitor the tenant trends as the pace of Philadelphia's office market is expected to slow this year. “Philadelphia seems to be slightly behind in its timing on the impact of these economic issues,” says CBRE's Marcus.

In the next six to nine months, more sublease space is expected to enter the market as the recession lengthens, he says. “We will continue to see short-term renewals by tenants and kind of a very slow year in general.”

Ben Johnson is a Dallas-based writer.

PHILADELPHIA - BY THE NUMBERS

LARGEST PRIVATE EMPLOYERS

  1. Jefferson Health System

    32,795 employees

  2. Comcast Corp.

    12,795 employees

  3. Merck & Co. Inc.

    12,500 employees

Source: Philadelphia Inquirer

CITY POPULATION

5.8 million

Source: U.S. Census Bureau

UNEMPLOYMENT RATE:

5.6%

Source: Bureau of Labor Statistics

METRO AREA VITAL SIGNS

Office:

11.7% vacancy, 3Q 2008

11.1% vacancy, 3Q 2007

$20.33 rent per sq. ft., 3Q 2008

$19.83 rent per sq. ft., 3Q 2007

Source: Reis

Multifamily:

4.9% vacancy, 3Q 2008

4.0% vacancy, 3Q 2007

$989 effective rent, 3Q 2008

$955 effective rent 3Q 2007

Source: Reis

Retail:

6.7% vacancy, 3Q 2008

6.5% vacancy, 3Q 2007

$18.13 rent per sq. ft., 3Q 2008

$17.95 rent per sq. ft., 3Q 2007

Source: Reis

Industrial:

7.6% vacancy, 3Q 2008

7.6% vacancy, 3Q 2007

$4.77 rent per sq. ft., 3Q 2008

$4.63 rent per sq. ft., 3Q 2007

Source: Reis

Hotel:

69.3% occupancy, 3Q 2008

73.8% occupancy, 3Q 2007

$120.35 average daily rate, 3Q 2008

$119.59 average daily rate, 3Q 2007

Source: Smith Travel Research

MAJOR PROJECTS

Comcast Center: Local office REIT Liberty Property Trust delivered this new marquee 57-story, 1.2 million sq. ft. structure, the tallest building in Pennsylvania, at 975 feet. It has changed the Philadelphia skyline. Comcast now occupies 90% of the building. One popular feature is the video wall in the lobby. It rises 25 feet and features high definition images. The state provided at least $30 million for public spaces in the building. A 16-story companion tower is planned.

Developer: Liberty Property Trust

Completion: June 2008

Cost: $523 million

University of Pennsylvania: As part of its bold “Penn Connects” plan the university purchased 30 acres of land from the U.S. Postal Service to connect Center City with West Philadelphia. The University plans to expand eastward to the Schuylkill River. Plans to develop a major office tower on the site by Brandywine Realty Trust stalled late last year.

Developer: University of Pennsylvania

Completion: Not yet available

Cost: $800 million (est.)