How Long Can Philly's Office Market Tread Water?
Real estate, especially commercial real estate, is an industry based on long-term decision-making. In a time when planning further than six months out is all but impossible, Philadelphia’s office market is treading water with some success.
Based on third-quarter office research reports from multiple real estate services firms, average asking rent has just about held steady in the Philadelphia metropolitan area, and while vacancy rates have predictably risen in the past six months, the rate at which they have done so is not indicative of a death spiral.
Greater Philadelphia posted 1M SF of negative absorption in Q3, CBRE estimates.
“The office market is slow-moving due to the long-term nature of leases, but a lot of the negative absorption in the quarter was the result of planned moves,” JLL Senior Vice President and Senior Research Director Lauren Gilchrist told Bisnow. “Some negative absorption has been as a result of the pandemic, but not all of it, which bears mentioning.”
Transactions dropped off by 48% quarter-to-quarter, according to Savills research, and leases that have been signed have been more heavily weighted toward renewals. JLL estimates about 50% of leasing transactions in the past two quarters have been renewals, as opposed to 29% pre-pandemic. Several Q3 renewals, including engineering firm AECOM’s 52K SF at 1700 Market St., have been short-term, Savills reports.
Despite this precipitous drop in leasing activity, asking rents have remained stable — possibly due to landlords’ reluctance to project an image of a property in decline. Office owners have been much more likely to offer concessions.
“There are so few prospects that I see rent abatements will continue to increase incrementally, and I think owners will reach a bit more on tenant improvements so that occupiers can spend less on fit-out,” CBRE Senior Vice President Kevin Maloney said. “Those two things will adjust more before you see a change in rents.”
Among the most common concessions that landlords have been offering prospective new tenants and renewals alike is more flexibility on the length of leases than ever before. The persistent uncertainty over whether various industries and individuals can anticipate economic relief from a stimulus package anytime soon or when a vaccine for the coronavirus will be widely available have the entire industry in a holding pattern. Landlords unwilling to discount asking rent have to make deals where they can.
“I think there’s been a lot of assessment by employers with a wait-and-see attitude,” Savills Research Manager Daniela Stundel said. “You’re hearing a lot of talk right now, but not seeing a lot of execution.”
For what few deals have been executed, over half have been for less than 10K SF, CBRE reports. That may be because smaller companies are at higher risk of failure due to coronavirus-related loss of business, Gilchrist said, echoing Avison Young Vice President Michael Sweeney’s comments on a recent Bisnow webinar. For such companies, or any business moving offices right now, there is an imperative to get right down to work as quickly as possible, if only to justify the continued cost of office space. Flexible, ready-to-use office space has received by far the most interest in the third quarter as a result.
“We find ourselves showing the same spaces over and over because the demand is all for the same space, with wiring finished and just a month or so of fit-out required,” Maloney said.
The supply of furnished office space is increasing across the Philly market as sublease availability has increased in both the suburbs and downtown core, Savills research indicates. Some landlords are negotiating with tenants looking to exit or shrink leases to make some sort of sublease deals, Maloney said, but keeping vacated space furnished and ready for move-in from the next tenant is growing in popularity.
Beyond smaller companies pressured to stay on top of their businesses, some larger companies based in Downtown Philadelphia are exploring flexible, suburban offices for a hub-and-spoke model to bring employees back to the office without requiring extensive use of transit. It could be considered an inversion of what was an emerging trend in previous years of suburban companies establishing urban outposts at coworking locations for young professionals living in the city and dreading a reverse commute.
The flexible office space that has proved popular in the past few months is different from coworking, in that it gives companies their own private space. Coworking is among the types of office suffering the most from current restrictions on workplace capacity, considering that it averages the highest worker-per-SF ratio of any major office type, according to JLL.
Though Philadelphia’s office market had never had a particularly high portion of coworking space (especially compared to San Francisco or New York), bankruptcy-related closures from IWG affiliates like Spaces and the shuttering of WeWork’s location at 15th and Walnut streets are among the market’s recent closures that weren’t part of pre-planned office moves, Gilchrist said.
Eventually, short-term fixes and holding patterns will be forced to make way for permanent decisions about office space. Gilchrist, Stundel and Maloney agree that a greater share of the labor force will permanently work from home compared to pre-pandemic levels, but employers and workers alike are eager to return to the office in some form, if only on a limited basis. A national JLL survey found that over 50% of workers would prefer to spend at least two days a week in an office.
“Anecdotally, my brokers have reported that young professionals do not want to work from home, because starting a career means building a network,” CBRE Senior Field Research Manager Joseph Gibson said. “And how do you build a network via Zoom? So workers will want to come back to the office, and there’s no longer the apocalyptic fear that there was in spring.”
There may no longer be “apocalyptic fear,” but the consensus among experts interviewed for this story is that a full return to the office will be impossible until the pandemic is contained. Even after that, office tenants may be encouraged to reverse the trend of maximizing shared spaces and employees per SF. A wellness-based need for more space could offset some of the losses that continued economic struggles will cause.
If the office leasing market continues to be as slow as it has been in the past two quarters, landlords will eventually be forced to decrease asking rents. With CBRE estimating that only 10% or so of office workers in the central business district are back at their desks, some companies may face fish-or-cut-bait moments with regard to their physical footprint as soon as the first quarter of next year, Stundel said.
JLL estimates 10% to 15% of office workers in greater Philadelphia are back at their desks, and projects that number will increase to 80% by the end of next year. Part of that projection is dependent on some progress being made toward a vaccine or treatment that allows the country to reopen more fully.
“If there’s no confidence that people will come back to the office in the spring or so, an office user could think, ‘Why am I sinking so much money into all this space?’” Maloney said. “‘If I’m not coming back for 18 months, I’ll save 18 months of rent, let my lease lapse and come back into the market for new space and get an abatement deal when I’m ready.’
“That luckily hasn’t happened with market-setting, large tenants yet. If we don’t get people back to the office, eventually, rents will erode.”