Q4 Current Future Market Conditions Report
With 100,000 SF of positive absorption, Philadelphia’s office market posted its first positive gains in seven quarters. Unfortunately, these gains didn’t put a dent in the 1,000,000 SF put back onto the market over the first three quarters. The CBD’s vacancy rate ended the year at 13.5%, with 6.1M SF available.
The Dawn of a New Age
A tenant-friendly market is once again upon us. The Philadelphia office market has become a competitive arena amongst landlords who are hungry for new tenants and desperate to retain existing tenants. Landlords and their respective agents can spin it a million ways to Sunday, but if anyone tells you otherwise, they are wrong. With more direct and sub-let space available in the market, there is an increase in competitive and flexible opportunities for tenants. An increase in opportunities for tenants means there is a boost in competition amongst landlords. Subsequently, as competition spikes amongst landlords, tenants will realize more options, which means a highly competitive environment will serve as the backdrop. Landlords will be in hot pursuit of any prospective tenant who gives them attention; thus, yielding the return of tenant-friendly transactions. If you are a tenant that does not take advantage of the existing market conditions, you will likely be remiss as landlords, at some point, will seek to recoup lost revenue and decreased profit margins to meet their debt service once again.
Tenants with leases that are expiring in the next 12-36 months are well positioned.
A New—But Different—Tenant-Friendly Cycle
The lasting results of the existing pandemic on the CBD office environment are very different than the fallout experienced during the Great Recession, which was the last tenant-friendly cycle spanning from 2008 until 2012. The Great Recession resulted in a flight to quality for tenants seeking to upgrade their image and location with nominal increases in operating costs. With construction prices at unmerciful levels presently, coupled with supply chain disruption and historic high base rents, we live in a very different environment. A significant difference between the two eras is that today businesses are questioning their commitment to office space, which is resulting in reluctance to pursue long-term commitments.
In the world that emerged post-9/11, it was common to hear that nobody would ever work in an office tower again. Of course, that faded quickly. Then, during and after the Great Recession tenants were reluctant to commit to a lease over five years. That quickly disappeared as well.
But this cycle is different.
Technology has evolved from what it was 10 years ago. Younger generations work differently than their Boomer counterparts, and people are questioning how and where they work. I do not believe it’s the end of office space, that’s impossible. However, I do think it will be a long time before we see tenants renewing office leases and pursuing a lease spanning 10+ years.
Will tenants relocate and have to commit long term? Yes, of course. But I think there will be a lot of short-term, low-capital renewals in the immediate future.
Traditionally, I do not like to discuss sub-lease space because it is considered shadow space—space that is available, but not considered vacant. However, we can’t ignore the amount of sub-lease space that has come back to the market in 2021. With 1.5M SF of sub-lease space available, tenants that are seeking alternative space, competitive rates, flexible terms, and leverage will not be at a loss to find it.
Tenant Roadmap:
- Abated Rent: One month of abated rent per year of lease term commitment.
- Tenant Improvement Allowance: $6-$7/RSF per year of lease term commitment in Class A space, and $5-$6/RSF per year of lease term in Class B space.
- Asking Rents are artificially inflated, sometimes as much as 10-15%.
- Lease Security: 2-3 months of base rent, with a reduction in the amount of lease security over time to one month as lease security.
- Termination Options: Are essential to any new lease, but the language that makes up the termination options is just as important, if not more than the options themselves. Ideal language comprises a 12-month notice period, and “exit payment” (payable on the effective date of the termination) in an amount not to exceed brokerage commissions and tenant improvement allowance using an interest rate of 6%. Anything else is cumbersome and makes the option virtually exercisable.
The above roadmap is only made possible with options, and leverage that is derived from time spent negotiating. Landlords will argue that a renewal transaction should yield less capital and abated rent than a new transaction but that’s hog wash. Why should a new tenant receive more capital and abated rent than an existing tenant?
The answer is simple, they shouldn’t, but a lot of existing tenants do not take the time to evaluate market alternatives. Regardless, if you are a new tenant, or a tenant renewing your existing office lease, you are entitled to what the market will yield. If you are an existing tenant, it will require more work and time. However, options and leverage will come, and it will be worth it.
Current Rates
Statistically speaking, rental rates have remained flat.
- Trophy Class space is priced at $43.75/SF
- Class A space is priced at $36.25/SF
- Class B space is priced at $28.25/SF
- Class C space is priced at $23.50/SF
In Closing…
While users of office space have returned to the office and will continue to return to the CBD, foot traffic is increasingly robust. I will close this update with this thought: Commercial office space lags the national economy by two years. Historically, Philadelphia has lagged other office markets by 6-12 months, generally speaking. Looking ahead, landlords are in for some tough sledding for the foreseeable future, and the CBD office market will be tenant-favorable in the interim.
Of course, if you have any questions, please do not hesitate to reach out and contact me directly. I am happy to aid.
I hope that 2022 has started off well for you and that you enjoyed the holiday season. I also hope that 2022 is a better year for all of us and that we continue to see a light at the end of this very strange tunnel we have all been in, collectively, for the past couple of years. Cheers to a [hopefully] a great year ahead of us!
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