Wednesday, September 6, 2017

Is Philly's Office Downturn Fast Approaching?

by Matthew Rothstein, Bisnow Philadelphia

Philadelphia’s office market is nearing the end of its cycle. Sale prices are down, most properties likely to change hands already have and some under-construction buildings look to have been mistimed.

Although FMC Tower is all but fully leased and stands as a success story, 2400 Market St. right across the Schuylkill River has yet to land an office tenant besides its anchor, Aramark. Developers Lubert-Adler and PMC Property Group are rumored to be nearing an announcement on that front, but until then, over 200K SF of office space is available as construction continues.

 “From a pre-leasing standpoint, they did a great job [at 2400 Market], but the momentum hasn’t been maintained." 1100 Ludlow, one of two towers rising as part of the East Market development, has signed MOM’s Organic Market as a retail tenant and Bohlin Cywinsky Jackson and the Design Center as office tenants, but has not signed any new leases for months.

One Franklin Tower, also developed by PMC Property Group, was once the home of GlaxoSmithKline before the pharmaceutical firm moved to the Navy Yard, and its redevelopment to a residential/office mixed-use has yet to land an office tenant.

Older Class-A buildings in the central business district, like Liberty Place and 1735 Market — and even FMC Tower’s sister building, Cira Centre in University City — have large blocks of space available, giving prospective office tenants looking for top-of-the-line space options beyond the newest product. “The cost of construction was something that drove them to consider a previously existing building in the trophy market." As for those prospective tenants, that is a problem in itself. Most are out-of-town or suburban-based businesses looking to establish smaller, satellite office spaces in the city rather than establishing large headquarters. Buoyed by the Gateway Philly incentive program, that pool has become a “great class” of office users.

While it may seem like the issues slowing down leasing at under-construction projects translate to a glut of office space, the type of tenants that they and competitors like Liberty Place are targeting for large blocks have virtually no options beyond the ones mentioned, meaning Class-A office is still in a space crunch with low vacancy rates overall. “There’s always space available, and the trophy market is tight, but that doesn’t mean there aren’t options for tenants to leverage competition to get good deals in the marketplace."

 Even with few options, there do not seem to be enough large tenants shopping around to fill what vacancies there are. If a large company were shopping for space, it would not necessarily be common knowledge, but job growth projections and historical factors do not seem to be in Philly’s favor to add a substantial employer. The slowdown in leasing activity could be the result of a series of upcoming lease expirations, with tenants and landlords waiting to see just how the market shakes out in 2018 and 2019.

Most potential tenants are kept under wraps due to competition among brokers, but multiple sources confirmed that law firm Morgan, Lewis & Bockius’ lease at 1701 Market St. is expiring soon, and it is weighing a renewal against a potential move. In a few years, more space will potentially be available, and not just due to expirations. Once Comcast’s Technology Center is complete, the cable giant will exit certain blocks in nearby buildings to consolidate. That being said, we predict further expansion from the company to offset such exits, and perhaps even increase its overall footprint in Philly. “At some point, Comcast will grow, and they may restack and refurnish their headquarters in 2018. And you would think that would allow for [temporary moves] while the phasing takes place.” Alternatives to Center City could also provide more options for large tenants, further muddying the waters for Class-A landlords. The Navy Yard has copious space, tax incentives and extensive ability to build-to-suit, which is what drew GlaxoSmithKline out of Center City and could potentially do more of the same in the coming years. Camden’s under-construction waterfront project is also meant to entice potential office tenants away from Philly.

“[Camden]’s a little bit more of an outlier, but it’s able to do large projects as a function of the sites and tax incentives available,” Gilchrist said. “Whether it can pull from Center City remains to be seen.” Further into the future, projects like Schuylkill Yards and uCity Square are undoubtedly looking for pre-lease tenants for what promises to be the next wave of flagship and high-tech office buildings in Philly, closer to the talent base that Drexel and the University of Pennsylvania provide. By then, the next cycle will likely have begun. Until then, office sales are telling a similar story about Center City as a softening market. Velocity and average price have both declined sharply this year relative to 2016’s historic highs, but the CBD is losing ground to the suburbs.

Three office properties, two in Malvern and one in Conshohocken, have sold for well over $200 per SF this year, while not one in Center City has cracked the $200 barrier. The gap in price per SF between the city and the suburbs shrank from $41 in 2016 to $26 so far this year, and is projected to narrow further in the next 18 months. Part of the decrease in price can be attributed to a spike in business property taxes, anywhere from 35% to 155% for landlords to take effect next year.

Many could appeal the new assessment handed down by the city (the deadline is in October), but if the tax bill on a property is higher, “it’s going to have a huge impact on pricing. We haven’t seen anything really trade since this assessment went into effect, but it could definitely make investors cautious." If prices are dropping, some might think it would make investors more excited to jump in before they rise again, but the opposite is happening: The market has cooled down after the heat wave of trading in 2015 and 2016. “When you look at this cycle, you begin to realize that a lot of what was available to trade has traded by now. Whoever has wanted to jump in, pretty much has. There’s not much left to buy in the CBD, and subsequent to that, we’ve seen a lot of expensive trades in the suburbs.”
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