Experts Disagree On The Health Of Philly's Office Market
Vacancy and rents are both rising in Philadelphia’s office market, but there is little consensus about just what it means.
The first quarter saw mildly positive absorption in the city's central business district according to a CBRE report, but vacancy is still higher than it was halfway through last year. At the same time, average rent in the city cracked $30/SF for the first time ever, which CBRE Director of Research and Analysis Ian Anderson chalked up to an increase in concessions so that landlords can hit their pro forma obligations.
“We’re seeing weakening fundamentals for office, and it’s going to deteriorate further over the next year,” Anderson said. “Does that mean its calamity, or a crash? No, it doesn’t, but next year we’ll see more vacancy and rents that we don’t expect to decline, but they are not going to rise like they have over the past two years.”
Much of the rising vacancy is due to large office users taking less space per employee, and thus shrinking their footprint for reasons entirely separate from losing money or staff. That has left blocks of empty space all over the city, but very few of the size that another large user would require.
The city’s office market is largely dominated by smaller users, who have been the main driver of 1.4M SF in net demand over the past three years, according to JLL Research Director Lauren Gilchrist. Such demand from smaller users has been a “stabilizing factor” to balance out all the consolidations, Gilchrist said.
As new supply comes online in 2018, which Gilchrist called a “gangbuster year for deliveries across all asset classes,” the balance between larger users shrinking and smaller users filling in what has been left behind could be strained.
"There are really two things that are making this market weaker: There’s more supply of office, and more tenants are densifying,” Anderson said. “And there’s not enough [small users] to fill that hole.”
Office consolidation has been a discussion point for years now, but with many of the high-profile examples having already come to fruition, the end may be in sight.
“The densification trend is 10 years old at this point, but I think we’re 80% of the way through that process,” CBRE Senior Vice President Jerry Kranzel said.
When tenants require less space, it means that they can more easily justify higher rents for what they do occupy. The effect has been a consistent flight to quality in the past couple of years, as evidenced by the fact that FMC Tower has managed to fill up completely despite top-of-market rents.
Much of Center City, especially along Market Street, is filled with buildings from the 1970s or 1980s, giving them a very different look from the shiny FMC Tower or soon-to-be-completed Comcast Technology Center. As many of those buildings have changed owners in the past few years, new landlords have pushed hard to modernize their buildings with amenities, which has made them able to compete for tenants with all but the very top of the trophy class.
“In Centre Square, PHMC’s space is as nice and new and modern as any office space in the city,” Kranzel said. “It’s got exposed ceilings, lots of glass and an extremely modern space in a 1970s building. You can’t really change ceiling heights or window clearance without completely re-skinning, but older buildings can compete with the newer buildings. Then again, you aren’t going to see companies that decide between Centre Square and FMC Tower.”
Much of what has made Philly’s office market so healthy in the past few years has been the dearth of new construction. Without new supply flooding the market, there are not enough large blocks of space to draw a meaningful number of tenants away from the traditional Class-A buildings downtown. Only seven blocks of at least 100K SF are currently on the market in the city, and only one or two of those are over 200K SF, according to JLL.
“That’s a really small quantity, which means a large tenant would pretty much have to kick off a new building,” Gilchrist said. “If you’re a large user, you don’t have many options other than to renew.”
The influx of national and foreign investors buying in Philly has so far consistently invested money into the aforementioned older Class-A stock, to the point where the number of value-add opportunities in Center City could be drying up.
“I think that the next buildings to come on the market will be more stabilized, because once a building has been enhanced, then it’s contemporary,” Kranzel said. “And they’ll be stable until the expectations for amenities and such in the building change.”
One way of both amenitizing a building and filling in midsize blocks of space that has been growing in popularity is co-working. Though it has made a big impact on the city in terms of how office users consider their space, shared workspaces make up just under 2% of the city’s office footprint, according to CBRE — less than New York, even by percentage.
Everyone seems to agree that co-working is poised to grow considerably in Philadelphia and all over the country — JLL estimates that shared office space of some form or another could eventually make up 30% of office space nationally — but not every landlord is embracing the trend at the same pace.
“Tenant improvement allowances are significantly above market rate with co-working space, because the argument is that landlords are investing in the space," Gilchrist said. "For some landlords, that works for your pro forma, and for some it does not."
Still, as larger companies embrace the flexible nature of co-working, like IBM at 1900 Market St. and a sizable contingent of suburban companies using co-working to install satellite presences in the city, the movement will be hard to deny.
“Two years ago, there was a lot more skepticism of all these co-working companies and shared office providers, with their growth and how they’d affect owners and markets in the event of a downturn,” Anderson said. “Now, I think the sentiment behind all that has lessened quite a bit, so that these shared office providers and co-working spaces are going to be much more of an attractive benefit for landlords, even in the event of a downturn … Co-working tenants are still trying to sell themselves to landlords at this point. But that is likely to shift.”
With Philly's job growth still lagging behind the national pace, and the companies that are growing not taking up as much space as they once did, concern for the market's health is understandable. But with the market's barriers to entry, its supply pipeline soon to dry up and its potentially deep pool of smaller users to backfill, optimism seems just as earned.
Anderson and Gilchrist are as knowledgeable as anyone about the current state of Philadelphia, but they differ on the big takeaway from the year's first three months.
“The downtown Philadelphia office market is heading in a direction that is not favorable for owners," Anderson said.
“In our kind of property clock, we’re still solidly on the landlord-favorable side of the clock," Gilchrist said.
CORRECTION, April 17, 2:15 P.M. ET: A previous version of this article incorrectly stated the amount of net office demand in Philadelphia. This article has been updated.