By Tom Weitzel, managing director, JLL
The Philadelphia office market at the moment is running in place, which is to say that there is certainly energy being expended, but it is going nowhere fast.
Tenants and landlords alike are partnering with real estate experts to navigate this challenging time. However, while office users evaluate businesses and study workforces, the benefit of making a decision has not yet outweighed the downside of making a wrong decision, so most users are adopting a “wait-and-see” approach.
Tom Weitzel, JLL
Tenant Perspective
Tenants are finding it challenging to make long-term decisions about their office spaces given the lack of clarity in the future. Business leaders and executives are tasked with considering factors such as health and safety, productivity, profitability and overall employee morale on a daily basis as they evaluate their physical office space usage during COVID-19.
Throughout the region, executives continue to balance health and safety concerns with operational needs as they advance office re-entry plans. They are also assessing the current productivity of their employees compared to that at the beginning of the pandemic. Many companies that we have spoken with have cited declining productivity and creativity from their employees.
At the same time, these executives are weighing investments in technology and software security to support a prolonged work-from-home approach against the reality that these measures and devices have already been integrated into their offices.
A recent study conducted by global architecture firm Gensler found that 94 percent of employees want to return to the office in some capacity, and 70 percent prefer to spend the majority of their work weeks in the office.
Philadelphia’s office tenants are still evaluating the impact of the current situation and have not made permanent decisions to eliminate physical office spaces. In most submarkets, sublease space accounts for less than 2 percent of all available space, which is in line with historical averages.
We’ve seen no measurable spike in sublease space added, with only 47,000 square feet of new space delivered since the second quarter. The same is true in the surrounding suburbs, where only 266,000 square feet of sublease space was added across the 53-million-square-foot market.
Compare our low amount of sublease space added to that of tech-, finance- and energy-heavy markets like New York, San Francisco, Houston and Denver that have added a combined 6.5 million square feet in 2020 — and that’s just when counting blocks of space over 50,000 square feet. If regional tenants decide to reduce their footprints, sublease availability may not immediately reflect these changes until 2021 or later.
We are also seeing a dramatic slowdown in leasing activity — about 20 to 30 percent of what it was in 2019, depending on the submarket — due to a lack of decision-making, resulting in a static market. The Philadelphia CBD has only seen an increase of 40 basis points in vacancy year-to-date, while the vacancy in the suburbs is essentially flat. These challenges have led to a few trends for the average-size tenant:
• Reusable conditions: Since long-term investments in office space are harder for companies to make under the current environment, we are seeing an elevated interest in spaces offering reusable conditions.
• Shorter-term leases: Leasing activity that is occurring is primarily for shorter terms; 57 percent of leases signed in the surrounding suburbs were for five years or less.
Alternatively, larger users have fewer quality relocation options and require longer processes. For these reasons, larger projects continue to proceed.
Landlord Perspective
It’s an interesting and challenging time for office investors, which is why having strong relationships with your real estate professionals is essential.
Those who made value-add investments throughout the region over the last 18 months and have yet to complete their lease-up plans will find it very challenging to meet pro-forma rent projections. However, owners throughout the region who purchased a stable asset or invested pre-2018 are in much better position than they were during the 2008 financial crisis.
Loan-to-value ratios on acquisition loans for office buildings are generally lower than in 2008. Carrying less debt will allow landlords to absorb reductions in rent revenue. But Philadelphia landlords haven’t seen a major drop in rent collections yet — most are reporting collection rates of 95 percent or higher, suggesting the Paycheck Protection Program has done its job — for now.
Uncertainty and an overall lack of leasing activity will give tenants more leverage, but we don’t expect to see a significant reduction in rental rates. However, it’s likely that tenants might see an increase in rent abatement and tenant improvement concessions.
Philadelphia is not a “feast or famine” economy. Education and healthcare represent a much higher proportion of the total job market than the national average, and these jobs typically remain stable or even grow in a recession. While hospitals face revenue challenges, they are still an economic engine, and our strong life sciences base has continued its upward trajectory as the most active sector in the region.
Historically, these factors have minimized Philadelphia’s unemployment rate, which rose less than the national average in both the 2001 dot-com bubble burst and the 2008 Financial Crisis. A recent study by Moody’s Analytics & the Brookings Institute concluded that of the 50 largest metros, Philadelphia ranked third in lowest percentage of jobs in the most vulnerable sectors.
Source: JLL Research
A recent report from JLL found that nearly 96 percent of all office-using jobs are still intact following the onset of COVID-19. Additionally, Philadelphia does not feel the pressure of large vacant blocks or new construction projects that drive rents down, meaning the supply side of the market will not push rental rates down in the short term.
History shows that over the past two cycles, Philadelphia experienced the lowest levels of rent volatility compared to peer markets. With current rental rates at all-time highs in the Philadelphia CBD, current asking rental rates reflect that resilience.
In Conclusion
Tenants’ “wait-and-see” approach has led to a lack of leasing activity throughout the region and has limited supply of sublease space. Landlords’ strong balance sheets and high rental collection rates have also led them to take a “wait-and-see” approach.
Commercial real estate is slow to respond to a recession, but components associated with goods and services are quick to recover. Factor in low interest rates, $3 trillion in federal stimulus (and more expected), historically quick GDP recovery and the regional dynamics mentioned above, and the recession in Philadelphia should be short-lived. Perhaps those who want to “buy-the-bottom” should start negotiating soon.
As brokers, we suggest keeping a close eye on the volume of one- to two-year extensions. If there is indeed a surplus in short-term lease extension activity, this will cause a disproportionate bulge of expiring leasing in 2022 and 2023 with no supply-side outlet in sight. Depending on the health of the economy and where companies settle on office utilization rates, this could cause a spike in cost-per-square-foot for office space in just a few years.