Signs of Life
To say that the speculative office market is returning to health would be an egregious overstatement. Vacancy rates remain high — 16–19% in many cities around the country — and ribbon cuttings on new net square footage are at an all-time low, according to Jim Haughey, Reed Business Information economist.
But a pulse is being detected in the market, which has flatlined through the most recent economic downturn and ensuing recovery. "The downturn is over and things are picking up," says Richard Kadzis, spokesperson for CoreNet Global, an Atlanta-based association of corporate and commercial real estate executives. "We're seeing absorption rates going up and vacancy rates declining in most major metro markets."
CoreNet predicts a "conservative but positive growth trend" developing this year for the commercial real estate markets, with a 2% overall growth rate in new leasing activity nationally, says Kadzis. This unimposing number is due to the "considerable overhang of shadow space remaining from the real estate downturn," he says.
Recent construction spending has almost exclusively been put toward renovation, small office projects, and build-to-suit offices, says Haughey. As is the case in the residential market, many corporations are taking advantage of low interest rates to finance big additions or build new owner-occupied corporate buildings and campuses, says Robert Bach, national director of market analysis in the Northbrook, Ill., office of Grubb & Ellis.
With office vacancy rates in most metropolitan areas well above the 10% threshold that most developers look for before even considering building new, the speculative office environment remains severely hamstrung. Even if they wanted to, developers would have a difficult time convincing lenders to finance purely speculative office buildings. The 7 World Trade Center project in Manhattan, admittedly a unique situation in itself, is still the rare case of an office building being developed without an anchor tenant, says Dennis Friedrich, president and COO of Brookfield U.S., New York.
Instead, developers are focusing on signing anchor tenants and then adding additional speculative space to those projects, says Friedrich. Service firms, such as financial and law firms, are key anchor tenants for office projects in many areas of the country.
But improving absorption rates, along with moderate growth in the economy leading to the creation of 500,000 new office-related jobs in the last year, are giving lenders reason to consider financing speculative offices in some regions, says Haughey. His projection for 2005: an 11.4% growth in office construction spending, and perhaps even greater growth in 2006.
Grubb & Ellis's Bach concurs that the market is returning, "but it's very slow." He believes it will be three or four years before the office market reaches equilibrium (when rental rates are rising no faster or no slower than the rate of inflation), signifying the need for new office space. "There isn't much demand for speculative space except for a few areas in the country," he says.
Among major metropolitan areas, Washington, D.C., New York, and Los Angeles County have the lowest vacancy rates in the country and are among the areas with the most office space under construction. Let's take a swing around the nation and see how speculative office construction is doing in these and other key cities.
Thanks to the stabilizing influence of the Federal government and the lobbying firms and defense contractors who want a presence in the nation's capital, Washington, D.C., is the best office market in the U.S. The Capital City has a 7.1% vacancy rate and 5.3 million sf of office space under construction, according to Grubb & Ellis.
The District's history as a safe harbor in the office market enticed Brookfield Properties to become a player there in 2003, growing to 1.5 million sf of office space in 12 months. The combination of an anchor tenant and additional speculative space was enough to convince Brookfield to purchase 1625 Eye Street, a 12-story, 383,000-sf office building near the White House, from its owner-occupier Union Labor Life Insurance Co. before construction of the property was completed in 2003. Today, the speculative portion of the property is 80% occupied, Friedrich says.
One of the metro area's hottest submarkets lies across the Potomac River in Arlington County, Va., where development partners JBG Cos., CIM Group, and Trizec Properties are currently building a 1.1 million sf mixed-use property called Waterview in the Rosslyn business district.
"Washington, D.C., is strong in the city and in the suburbs," says Nicholas T. Makes, SVP and portfolio director with Turner Construction Co., New York. This month Turner is delivering the last of five buildings that make up the new 2.5 million-sf headquarters for the U.S. Patent & Trademark Office in Alexandria, Va. Turner is general contractor for the project, which includes a child-care facility, cafeteria, bank, library, health unit, and gym. The new campus brings together USPTO staff who were scattered in 18 different buildings in the Crystal City section of Arlington.
The U.S. General Services Administration, which signed a 20-year lease on the $500 million project, chose LCOR to develop the site and act as property manager, according to Lou Williams, project executive for the developer's Alexandria office. Gensler performed planning and consulting services and designed the interiors of the project, while Skidmore, Owings & Merrill designed the building envelope.
More than a million square feet of office space are under construction in the Big Apple, according to Grubb & Ellis's Bach. Norman Foster's Hearst Building, The New York Times Building, Freedom Tower, and Bank America Tower, most of which were well under way before 9/11, are among the most well-known projects. But in New York, financial services firms are the true drivers of the office market, says Brookfield's Friedrich. Many of these firms fled Manhattan in the wake of 9/11, which in many cases paved the way for large law firms to upgrade to more modern buildings while taking advantage of attractive lease and sublease rates. Friedrich says he's "never seen law firms driving the market the way they have in recent years."
The return of the financial service firms to midtown and downtown near the World Trade Center site has tightened office vacancies, particularly the large developments of more than 100,000 sf. Midtown vacancies are at about 11%, with downtown at about 12%, says Friedrich.
As in most cities, pre-leasing is still the name of the game in New York. Before going ahead with a project, developers typically require a 50% pre-leasing commitment, says Turner's Makes. In a scenario symbolic of the last up cycle, Brookfield's 35-story, 1.2 million-sf 300 Madison Ave. building, which opened in early 2004, began as a development for the Canadian Imperial Bank of Commerce's U.S. headquarters, says Brookfield's Friedrich. As the economy soured, CIBC downscaled, leaving a big chunk of the project, which was constructed by Turner, unleased. Financial services firm PricewaterhouseCoopers eventually occupied 800,000 sf of the space, giving the building two principal tenants.
To cater to the needs of the financial services firm tenants, the design (by SOM) emphasized column-free space, high floor-to-ceiling heights, and redundant power. Following 9/11, with the building in mid-construction, significant structural upgrades were made to the building to prevent the possibility of progressive collapse.
Similarly, in Space City, a design that's unique from the competition has helped the city's Calpine Center weather the stormy economic times. When Calpine, an electric power company, was forced to downsize, the building's developer, locally based Hines, was able to bring in two more tenants, including a law firm, keeping the building at 90% occupancy. Hines also registered the building in the U.S. Green Building Council's LEED for Core & Shell program.
Designed by HOK, the building faced stiff competition from three other office projects, which were coming online at about the same time the project was completed in 2003. HOK design director Roger Soto says the building took its cues from its tight site and its location in the fashionable theater district. Unlike its competition, the Calpine Center's design included a boutique-style lobby, devoting more space to public amenities like street-level retail and restaurants. The building's exterior granite and unitized glass curtain wall system give it a high-quality look, and its large floor plates appealed to tenants.
While the economy and office rentals in the city of Los Angeles are struggling, many submarkets of Los Angeles County are doing well, with vacancy rates ranging from 10% in the north San Fernando Valley to under 9% in San Diego. Even with a 15% office vacancy rate, large net absorption in West Los Angeles is rapidly making it the most desirable submarket, says Grubb & Ellis's Bach. "Some developers are jumping the gun a little, realizing that the market is improving rapidly and vacancy rates are low enough to support construction," he says.
Although the office vacancy rate in Chicago is high, at about 17%, the West Loop submarket in downtown Chicago is vibrant, with 4.4 million sf of space under construction. But the high vacancy rate in portions of downtown is creating a situation where Peter is getting robbed to pay Paul, says Bach. Businesses are vacating existing office space in the East Loop in favor of new office space closer to commuter trains in the West and Central Loop.
Among the spec projects under construction is the 980,000-sf 111 South Wacker developed by the John Buck Co. and scheduled for completion in June. One South Dearborn, an 820,000-sf spec office with Hines as developer, is due for completion in November; the giant Sidley Austin Brown & Wood law firm is primary tenant.
Hotlanta's office vacancy rate has hit a feverish 19%, yet it, too, is experiencing a resurgence in Class A office construction, both downtown and in its midtown, says Martin Brannon of locally based tenant representative firm Mohr Partners. "It's refreshing to see money is being refocused and turned back into the CBD," he says.
The most recent project to come out of the ground is the 24-story SouthTrust Tower at Atlantic Station, which opened last April. Located in midtown adjacent to the downtown connector on a brownfield site where once stood a steel mill, the 525,000-sf project is the first of several office buildings in the development. "When submarkets [such as midtown] are hot, you can get enough support to start a new development," says Grubb & Ellis's Bach.
The project was developed by AIG Global Real Estate Investment Corp./Atlantic Station LLC, designed by local firm Smallwood, Reynolds, Stewart, Stewart Associates, and constructed by local firm Hardin Construction. The goal: bring people back into the midtown area.
Because AIG was negotiating floor space with tenants well into the project, the number of floors in the building changed twice during the 16-month construction schedule, says Bill Pinto, Hardin's president and COO. "We knew going in that AIG might need more floor space," he says. During preconstruction, plans were made to install foundations to allow for 21 levels of office space instead of 17. To make projects such as this as flexible as possible, Pinto says collaboration in the preconstruction phase is essential. "Most changes take place before we actually get into the ground," he says.
Downtown, electric power company Southern Company is relocating from its long-time headquarters building to Southern Company Center @ One Centennial, a 259,000-sf build-to-suit property being developed by Barry Real Estate Companies. Designed by local firm MSTSD Inc., the eight-story headquarters building (due for completion by Hardin Construction in October) is built atop a seven-level parking deck and ground-floor retail space. "The office buildings we are seeing all introduce an element of ground-level retail," says Hardin's Pinto.
When prestigious law firm King & Spalding moves into its new 1180 Peachtree headquarters office, the 41-story building will be one of the city's tallest. Developed by Houston-based Hines, the $100 million project — yet another LEED Core & Shell entry from Hines — was designed by Jamco, Marietta, Ga., with Turner as GC.
As the speculative office market begins to gain momentum toward more sustained growth, developers will be asking Building Teams to make their offices flexible, yet cater to the demands of the service firms and businesses that are footing the bill as anchor tenants.