W.C. Fields was right -- Philadelphia is a little boring. But in these volatile times, the city’s safe, stable real estate market is nothing to laugh at.
By Jill Andresky Fraser
October 2002
Institutional Investor Magazine
Economists may fret about a U.S. residential housing bubble, but they harbor no such fears about the commercial property market. The national office vacancy rate is running at an uncomfortably high 16 percent, up from just over 10 percent at the beginning of 2000. In major cities such as Boston, Chicago, Los Angeles and San Francisco, the rate exceeds 20 percent. Blame a sluggish economy, widespread corporate cutbacks and the lingering effects of excess supply in the system. Many tenants, saddled with space they no longer need, are dumping millions of square feet onto an already soft market.
But not every office market is struggling. Small and decidedly low-profile, Philadelphia is holding up remarkably well. The city, with 36 million square feet of space, compared with 360 million for New York City and 110 million for Washington, sat out most of the late ‘90s real estate boom in the shadow of its northeastern neighbors. But today Philadelphia enjoys commercial rental rates that have remained quite stable, averaging $21.21 per square foot, down only slightly from the 1999 peak of $21.64 per square foot, according to a midyear report from CoStar Group, a Bethesda, Marylandbased consulting firm. The city’s commercial vacancy rate of 13.15 percent remains below the national average, though it is up from 10.1 percent a year ago -- inescapable fallout from the recession.
“The Philadelphia market represents safety, and safety today is very much in vogue,” says Woody Heller, an executive managing director at New Yorkbased Insignia/ESG. “In Philadelphia you’re not going to get that much swing when it comes to rental or sale prices. You won’t enjoy much euphoria during the high moments, but you won’t get creamed when the market is bad.”
In addition to the city’s traditional lures -- a central location along the northeastern corridor and an excellent transportation network -- Philadelphia is enjoying a revival of its once-sleepy downtown. Several office buildings have been converted into hotels, and dozens of new restaurants have debuted. One acknowledgment of the city’s newfound chic: A recent Condé Nast Traveler survey of the 50 best U.S. restaurants included seven Philadelphia establishments.
“The city has become a big draw for empty-nesters and young professionals, who now want to live downtown because it’s the place to be,” notes Scott Janzen, a principal in the Philadelphia office of Lend Lease Real Estate Investments, an Atlanta-based firm that manages a $35 billion real estate portfolio.
Signaling the market’s strength, the 588,000-square-foot 1650 Arch Street office building attracted 16 offers when it went on the block several months ago. “You’d expect that in New York, not Philadelphia,” says Michael Margolis, a senior managing director at Insignia/ESG. In August 1650 Arch sold for $71.5 million, or $122 per square foot. The building’s lead tenant, a local law firm, has a long-term lease, which makes the property especially desirable.
In June the trophy Two Liberty Place property sold for $200 million, or $167 per square foot. That price is more than 20 percent higher than any other Phil- adelphia transaction in the past 18 months, reports Steve Sakwa, a Merrill Lynch analyst. The buyer of Two Liberty: a $609 million equity fund raised late last year by Shorenstein Co., a San Francisco based investment firm. TIAA-CREF is serving as the first mortgage lender on the building, which is fully leased to Insurance Co. of North America.
Notes Youguo Liang, managing director of investment research for Prudential Real Estate Investors, a Parsippany, New Jerseybased firm that manages $11.7 billion in real estate investments: “Philadelphia isn’t perfectly countercyclical, but it is a defensive play because it’s a more stable city with potential opportunities in all real estate sectors. Historically, it’s never behaved in tandem with cities like Boston or San Francisco. That can be appealing.”
The city draws on a well-diversified tenant base, which includes financial services companies like Mellon Financial Corp. and PNC Financial Services Group, pharmaceuticals companies such as GlaxoSmithKline and old-line manufacturers like Crown Cork & Seal Co. But with a stable demand for office space -- “Washington, D.C., in an average year adds 50,000 new jobs, while Phil-adelphia will only do that in the very best of times,” says Lend Lease’s Janzen -- Philadelphia didn’t attract a single new office construction project from 1991 through 2001. In fact, the city’s downtown lost office capacity, thanks to some conversions of prewar buildings into hotels and residential apartments.
During the 1990s, says David Rubenstein, CEO of Rubenstein Co., a Philadelphia-based real estate investor: “We had good absorption of office space. But it never happened at such high levels that it caused rents to reach those peaks that would have led to a lot of new construction in the central business district. That means that the downtown supply never really got overextended.”
The suburbs, on the other hand, have recently attracted a flurry of new construction projects. In early 1999 the city’s 16 suburban submarkets housed nearly 2,700 commercial buildings; at recent count, reports CoStar, there were 2,826, with 25 new properties completed during the first half of this year alone. As a result, two of the more developed suburbs, Conshohocken and King of Prussia, post vacancy rates of more than 20 percent.
Within the city limits some commercial rents have recently softened a bit. Thomas Ashforth, senior vice president of investments at Ashforth Co., a Stamford, Connecticutbased, family-owned real estate investment firm, points to three mostly vacant class-A buildings on the outskirts of downtown -- Four Penn Center, United Plaza and Three Parkway. “They’re starting to depress rental prices because they’re taking some pretty drastic steps to attract tenants,” Ashforth says. “That’s going to hurt, at least for a while.” When Four Penn came on the market in 2000, its owner was asking $28 per square foot; recently, 60,000 square feet of space reportedly rented for $20 per square foot.
Yet Ashforth remains optimistic over the long term. “We remain firmly committed to the Philadelphia market,” he says. In June his firm closed on a $109 million deal to buy 1818 Market Street, a 980,000-square-foot office building located in the heart of downtown. “This is a wonderful property with tremendous city views and a great location. We intend to invest $5 million on upgrades in the hopes of commanding high-end class-A rents in the range of $24 to $25 a square foot,” he explains.
Two years ago Ashforth Co. launched a study to identify undervalued markets with significant growth potential. Philadelphia emerged as a major new target for the company, along with San Diego and northern New Jersey. “There are a lot of strong macro reasons for Philadelphia’s appeal,” he says. “Transportation is one of them -- there’s a great road network in the city and suburbs; a great train network; and a very good airport, offering more international flights a day than Boston’s Logan International Airport. The city should have a great appeal to businesses, especially those looking to diversify or relocate.”
When Ashforth set its sights on Philadelphia, a downtown revival was just under way. Loews Hotels converted the former PSFS Building, a landmark bank headquarters, into a 583-room hotel; the old Mellon Bank Building, across from City Hall, became a Ritz-Carlton Hotel Co. property; and Marriott International converted the Reading Headhouse Terminal on Market Street, formerly part of the Market East train station complex, into an extension of one of its hotels.
“These were high-profile conversions of downtown office space into high-quality hotels,” notes Heller of Insignia/ESG.
During the past three years, developers converted eight office buildings into apartment houses with about 2,000 units, with the renovation of a further 1,000 units now under way. That’s a significant boost in supply, but demand should remain strong. Edward Riedlinger, a Horsham, Pennsylvaniabased senior vice president and regional market manager for GMAC Commercial Mortgage Corp., points out that a year ago downtown rental apartments were about 97 percent occupied. “The market is still in the 94 to 95 percent range,” he says.
Sale prices remain robust. Ashforth paid about $110 per square foot for 1818 Market; a comparable property in midtown New York might sell for $325 per square foot and in Washington, D.C., for $315 per square foot, according to Insignia/ESG. In May Thomas Properties Group bought 11 Penn Center, located at 1835 Market Street, from the Ohio State Teachers’ Retirement System for about $83 million -- a price of about $120 per square foot for the 685,000-square-foot building.
“Buildings have been selling straight through the downturn,” notes Riedlinger, who adds that “sale prices have tended to average $110 to $130 per square foot, which is far below replacement cost. But these price levels are completely appropriate given rent levels, which are way below what tenants would pay in places like New York City and Washington, D.C.” According to CoStar, the average asking rental rate per square foot for a class-A office building in midtown Manhattan is $52.95 (plus electric) and $37.72 (full-service) in Washington, D.C.; that compares with $22.71 (full-service) in downtown Philadelphia.
What’s ahead for Philadelphia’s real estate market? Growing institutional investor interest, the downtown boom and the prospect of potential new demand from relocating corporations are sparking new construction activity.
Liberty Property Trust, a Malvern, Pennsylvaniabased real estate investment trust with $4.2 billion in assets, is embarking on a $470 million development of Pennsylvania Plaza, a site bordered by 18th and Arch Streets in downtown; Liberty will continue to be the sole owner of the property. “We believe this will be the finest office location in greater Philadelphia,” says John Gattuso, a senior vice president for marketing. The complex will include a 52-story tower with 1.2 million square feet of office space, a half acre public plaza, two smaller office buildings and a 110-foot-high winter garden that will provide access to the city’s suburban train station.
Still, Gattuso reports, “We won’t get started without an appropriate amount of preleasing committed.” He says that a significant number of Philadelphia commercial leases will expire over the next couple of years. “That’s one reason why this project makes sense now.”
The other significant new project comes from Brandywine Realty Trust, a Plymouth Meeting, Pennsylvaniabased REIT that owns an entertainment center in downtown Philadelphia and several properties in the suburbs. Recently, Brandywine announced its plans to develop a $150 million to $200 million 600,000-square-foot complex of office buildings, restaurants and retail outlets on an Amtrak-owned site adjacent to Phil-adelphia’s 30th Street Station. The architect, Cesar Pelli, also designed London’s Canary Wharf and New York’s World Financial Center. “This project has a unique appeal,” says H. Jeffrey DeVuono, a senior vice president for operations. One definite draw: Tenants will qualify for 13-year state and local tax abatements.
Nonetheless, DeVuono cautions: “We’re not going to build this on spec. If we were 60 percent preleased but there wasn’t a lot of backlog interest out there, we probably still wouldn’t do it. There’s got to be a lot of strong activity before we proceed.”
Betting on strong demand for residential space, Lend Lease, in a joint venture with P&A Associates, a local real estate firm, is developing a 46-story apartment building downtown on Washington Square, at Seventh and Walnut Streets. “We looked at the success of some of the residential conversions downtown and identified this as a good niche -- luxury units in a building that was designed from the get-go for residential living,” says Janzen. Lend Lease has put up about 85 percent of the capital stake.
Such optimism is infectious. These days the Philadelphia office market is as juicy as a cheese steak.
