Philadelphia's Office Market Has One Last Gasp Left In This Cycle

At this point, it may sound like a broken record: This economic cycle isn’t over quite yet. Although Philadelphia's office development pipeline is about to dry up, one key factor will add at least one more boost to leasing activity before all is said and done.

A high number of leases across Philadelphia are set to expire in the coming years — 1.3M SF in 2019, 1.5M SF in 2020 and 1.5M SF in 2021, JLL Research Director Lauren Gilchrist said. Until those tenants renew or find different space, landlords will continue to behave as if the market has not hit its downturn yet, with asking rents holding steady in Class-B office space and rising in Class-A space in the second quarter.

“Conventional wisdom thinks that it’s all downhill from here,” CBRE Research Director Ian Anderson said. “Maybe not rapidly, but slowly but surely downhill. But our data shows that there will be a late-cycle surge here occurring over the last six months [of 2018].”

Despite the upcoming boost, it is now safe to say that this cycle’s best days are behind it. Even ahead of massive deliveries like the Comcast Technology Center, Aramark’s new headquarters at 2400 Market St. and the next phase of uCity Square at 3675 Market St., Philly’s central business district experienced negative year-over-year absorption in the second quarter, according to JLL and CBRE's Q2 reports.

It seems that over the past few years, every time a major tenant's lease ended, its next one was for less space, either in place or at a new location. Though that trend is more tied to shifting space requirements than job losses, job growth in the city has slowed from its peak in this cycle, which was already behind national averages.

Due to the area’s prohibitive construction costs, an outsized portion of the space coming online is already leased — 87% of the 3.1M SF under construction, which is among the highest percentages of any major market in the country, according to CBRE. That will prevent a massive rise in vacancy, but combined with the sluggish job numbers, it means that those expiring leases are unlikely to send absorption numbers back into the black.

“There is a little concern based on a slowing of net new demand, but for large tenants at this stage looking at the large blocks of available space, there is [less than one block] for each tenant that needs it,” Gilchrist said. “So many of those tenants are going to be stuck in spaces they occupy and renovate in place, or face stiff competition in those other blocks of space. And that will cause landlords to remain bullish on their space for the next couple of years.”

Though Anderson and Gilchrist disagree on whether the available blocks in Class-A buildings will be enough to fill all prospective tenants' needs, both of them express doubt that a tenant squeezed out of available space would opt for a new build-to-suit.

“To kick off a build-to-suit, you need to be a tenant of size, at least 100K SF,” Gilchrist said. "But even if you are a tenant of that size looking at Schuylkill Yards or 1301 Market St., those projects will require at least 50% pre-leasing, and that’s at least 300K-400K SF to get a building financed. So there will be a lot of competition in existing spaces, and if you want to kick off a new building, it will be a challenge assembling those requirements.”

The Navy Yard is also an option, but is less likely to draw a tenant away from Center City as it is to entice a company based in suburbia to get closer to the urban core, Gilchrist said. As AmerisourceBergen proved with its deal to become an anchor tenant at Keystone Property Group’s SORA West development in Conshohocken, opportunities for custom offices are easier to find outside city limits.

A couple of larger suburban tenants are also approaching their lease expirations, and existing stock there is not as enticing as what is available in the CBD. Another development or two in Conshohocken are awaiting anchor tenants to kick off, and the town’s combination of highway access and public transit keep it as the most likely area for another office development, Gilchrist and Anderson said.

Philly’s suburbs have recovered more slowly from the recession than the CBD, which means that the downturn will likely hit there later, too. Job growth has yet to stagnate out there like it has in downtown, which Anderson and Gilchrist said is more due to cyclical influences than any effects of the city’s bemoaned tax structure.

Those taxes could be compounding the densification issue in the city, according to Gilchrist, with companies unwilling to bet on any major expansion while they are unable to predict what their tax bill will look like in a year. That could be what finally ends this cycle locally, and President Donald Trump’s unprecedented criticism of the Federal Reserve’s interest rate hikes could do the same on a national scale.

“We will be seeing rising interest rates, and to me that represents the tail end of the cycle,” Gilchrist said. “That and the [Trump-related] instability is creating a lot of uncertainty for business expansions, and when they’re hesitant to move or expand, that tends to quell the office market from a leasing perspective.”

Many of the new leases that Philly expects will be signed within the next year, and without an unexpected reversal in job numbers, that means the cycle might finally end in 2020, Anderson said. But in the meantime, the city is likely in for a busy few months.