How to spot recovery

Another great article in the Inquirer this morning about CRE and recovery.

Special Report: Commercial Real Estate's Troubles

Exactly when the Philadelphia region's distressed commercial real estate landscape will shed its "Space Available" banners is uncertain.

Some experts suggest recovery is a year away. Others lean closer to three years, given that two significant changes must precede it: employment growth and a resumption in lending.

What's more predictable, those experts say, is what the recovery will look like.

One of the first signs of a turnaround will be a spike in rents - a basic function of demand outpacing supply.

In the office market, currently not considered overbuilt and not expecting new spaces for at least three years, "I think you'll see 20 percent" rent increases, said Sid Smith, managing partner of the regional office of Newmark Knight Frank Smith Mack, a global real estate services company.

As for the rest of commercial real estate's postrecession constitution, expect a "new normal" premised on lessons learned over the last year of pain, said Jim Mazzarelli, regional director of Liberty Property Trust, a major landlord in this area, with about 10 million square feet of office space.

For one, landlords will not assume that tenants, especially established, high-profile tenants, are forever. As a case in point, real estate professionals refer to this year's dissolution of the venerable Wolf Block law firm, which added 175,000 square feet of vacancy to Philadelphia's Market Street West submarket.

"The days are gone when you would [assume] a major law firm would be around for 60 years and give them $10 million in [building-improvement] capital," said Dave Campoli. He is a regional vice president for HRPT Properties Trust, a national real estate investment trust with nearly 5 million square feet of commercial office space in Philadelphia.

In the new world, Campoli said, such a law firm likely will have to put up a portion of the cost of any site improvements it wants.

Tenants will be choosier, too, he said, doing more vetting of landlords to verify whether they have the financial foundation to fulfill promises made at the time a lease is signed.

That will lead to what Liberty Property's Mazzarelli calls "flight to a stronger brand." It's a pattern he contends will dominate commercial real estate decisions when the economy picks up.

Traditionally, economic downturns have triggered so-called flights to quality in the office market. That's when tenants take advantage of depressed rents and move to higher-end buildings whose rents in boom times were beyond their budgets.

At the heart of "brand flight" will be tenant concern over "who's going to take care" of them once they move into a building, Mazzarelli said.

"Companies that are in a tough business environment don't want to have to worry about the real estate they're housed in," he said. "They don't want to worry about the roof leaking or whether taxes are being paid."

What kind of buildings will fill up first when businesses resume the hunt for space?

When it comes to big-box retail, early indications suggest the answer is: big-box retail.

Brandon Famous, chief executive officer of Fameco Real Estate L.P., a broker of retail space, said electronics retailers trying to break into this market have been "scouring" the region for empty Circuit City stores and signing leases at rental rates nearly half what was being charged three years ago.

In the office market, the properties offering energy-efficient, sustainable features will be in highest demand, and not necessarily because tenants have had a green consciousness-raising, said Brenda Gotanda, a partner and specialist in green building at the law firm Manko, Gold, Katcher & Fox L.L.P., of Bala Cynwyd.

Interest will come as much from a recession lesson - that no cost-saving opportunity can be ignored - said Gotanda, who represents owners of office buildings, including Liberty Property Trust.

In Pennsylvania, she said, added impetus for property owners to incorporate features such as solar panels, motion-detection light switches, and automatic window shades will come from the double-digit increases in energy prices expected when state-imposed electricity-rate caps expire next year.

At HRPT, Campoli does not disagree. But he said selling green features to tenants as a long-term cost-savings measure might not be easy - at least not in the early stages of an economic recovery - if it means boosting rents to help cover installation costs.

He speaks from experience. When he recently proposed some green features in one of HRPT's properties, warning a major tenant that those additions would result in a rent increase, Campoli said the tenant replied, "Why don't you have a blood drive if you need to feel good?"

In today's offices, "it's just survival mode right now," Campoli said.

It's a little like that in Matthew McManus' world, too. He is chairman of Bluestone Real Estate Capital, an investment bank for real estate investors, primarily in three sectors - multifamily, hospitality, and health care.

"We had a very scary 2008," he said recently, noting that the nearly $400 million in business his firm closed that year involved deals made in 2007.

So far this year, Bluestone has closed just under $250 million in business, McManus said. But out of this slow time has come innovation.

Working with developer Bart Blatstein, Bluestone is pulling together an institutional-equity fund of between $100 million and $150 million that will start making investments the first quarter of next year in Philadelphia and the surrounding counties.

"We're subscribing to the belief," McManus said, "that risk can be controlled by investing in your backyard."