Strong Demand, Record Rents Drive Office Investment, Development in Philadelphia
Robust employment and population growth are fueling Philadelphia’s renaissance and propelling the region’s office sector to new heights. The lack of new office construction over the past decade has driven rents to record levels and is creating value-add acquisition opportunities throughout the region.
With a tight labor market and talent acquisition at a premium, companies want to lease state-of-the-art workspaces that attract future employees. Key features of these spaces include access to public transit and surrounding retail and restaurant options.
Limited availabilities within this product type are driving rents for quality space, as well as the development pipeline for new office buildings. However, after years of little construction, several proposed office buildings in both downtown and the suburbs are close to breaking ground and creating the next crop of new office inventory for the region.
In the second quarter of 2019, average asking rents for office properties in downtown Philadelphia hit a record $31.33 per square foot, a 20 percent increase over the past five years.
This growth has been driven by out-of-town investors acquiring buildings and raising rents, as well as by growing demand for downtown office space, both from new in-bound demand and organic growth from existing tenants.
Despite rising rents, construction costs still outpace rates downtown, which is why there is no speculative office development in the CBD. Ground-up new construction is limited to the relocation and expansion of Fortune 500 company headquarters, or to office buildings in Keystone Opportunity Zones (KOZ) outside the core of downtown, where companies get tax incentives to locate there.
Downtown’s scarcity of new construction is the reason office inventory has remained constant at the 40 million-square-foot level over the past 20 years. While new product is slowly added on, older inventory is consistently taken off through the redevelopment of Class B and C product into residential or hotel.
This creates a barrier to entry and protects the value and vacancy rate of existing downtown office space. It is this constraining market dynamic that is driving a flight to quality from tenants who are willing to pay a significant premium for modern and amenitized buildings.
Office rents in the Philadelphia suburbs are also pushing record highs, hitting $27 per square foot in the second quarter, a 10 percent increase over the past five years. Rising construction costs and tenant demand for high quality, modern office spaces are driving asking rates at the high-end of the market.
Buyer Pool Expands
Since 2015, out-of-town buyers have invested $2.5 billion in the CBD’s office market, representing 78 percent of the 18 million square feet sold during this period.
Institutional investors are attracted to downtown Philadelphia’s strong market fundamentals, higher yields relative to other East Coast cities, abundance of value-add opportunities given an aging office stock and the fact that properties can be acquired at a considerable discount to replacement costs. New owners like Shorenstein, Nightingale and Silverstein are repositioning aging assets and successfully pushing rents.
Rising rents and a limited supply of large blocks of space in trophy buildings are driving demand for new office construction in the CBD. Parkway Corp. is in active negotiations with large tenants to build two office towers within the core of downtown Philadelphia. Not including Comcast’s two headquarters buildings, these would be the first ground-up new construction office towers in the CBD since 1992 if either is constructed.
The expectation is that this trend will continue, with other 100,000-square-foot-plus tenants in the market seeking trophy space and 5 million square feet of office space in the proposed stages. This new supply includes Brandywine Realty Trust’s Schuylkill Yards and Wexford Science & Technology’s uCity Square, both in KOZ areas within University City.
Since the recession, there has been a lack of new office construction in the suburbs, where the median building construction date is 1986 and less than 4 percent of current inventory has been built over the past 10 years.
As with downtown Philadelphia, tenant flight to quality and a shortage of this type of office product is driving Class A rents, as well as the renovation of older properties and new office development in the suburbs. This is particularly true of live-work-play or transit-accessible submarkets that are commanding higher rents.
In the suburbs there is currently 1.1 million square feet of office space under construction, including Keystone Property Group’s 427,000-square-foot Conshohocken office building that will house Amerisource Bergen’s new headquarters once complete in 2020.
Additionally, there is 1.2 million square feet of proposed office projects in the pipeline, a majority of which are in the King of Prussia, Conshohocken and Main Line submarkets. Developers like Brandywine Realty Trust, Equus Capital Partners and Oliver Tyrone Pulver are leading this activity.
While traditionally considered a slow and steady market, Philadelphia’s office sector is currently in expansion mode. With jobs continuing to go unfilled, the expectation is that tenants will continue to pay a significant premium for the modern and well-located office space employers need to attract the best talent. Strong market fundamentals are driving investor activity and rents to record highs, which are beginning to catch up to the cost of new construction.
— By Casandra Dominguez, director of research, Cushman & Wakefield. This article first appeared in the August-September issue of Northeast Real Estate Magazine.