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COVER STORY, APRIL 2007
CBDs SHOW UPSIDE
Job growth has western CBDs standing tall again.
Nick Slonek, Nick Papa, Casey Mills, Mike Hamasu and Sandra Grove
Whether it’s job growth in the Aloha State’s biggest city, an office construction boom in Seattle or unprecedented investment levels in the City by the Bay, Central Business Districts (CBD) across the West are bustling with activity. Western office players are following Petula Clark’s advice and going downtown.
San Francisco
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San Francisco’s CBD experienced unprecedented office investment sales in the first quarter of the year.
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The San Francisco commercial real estate market has experienced unprecedented investment activity at record underwriting prices during the past few months. The aggressive underwriting continues to stimulate significant increases in asking rental rates in the city’s CBD. In fourth quarter 2006, annual asking rental rates for Class A office space averaged approximately $40 per square foot. Due to recent investment transactions, one should anticipate those asking rates increasing as much as 20 to 30 percent this year.
While the San Francisco investment climate has escalated tremendously in the past 24 to 36 months, first quarter 2007’s landmark portfolio sales underscore the influence high sales prices have on increasing rental rates. As an example, after purchasing Equity Office Properties, Blackstone disposed of the company’s San Francisco portfolio. Morgan Stanley purchased these properties for approximately $2.8 billion. Trophy buildings One Market Street and One Maritime Plaza were underwritten for more than $950 per rentable square foot each or, in annual rental rates, more than $80 per square foot for each asset. 150 California Street, 201 California Street, 580 California Street, 201 Mission Street, 60 Spear Street and 188 The Embarcadero — also part of Morgan Stanley’s acquisition — were each underwritten at more than $700 per rentable square foot or approximately in the mid-$60s per square foot in annual rental rates.
In another important portfolio purchase, Broadway Partners bought Beacon Fund III from Beacon Partners, a transaction including San Francisco properties 50 Beale, 100 California, 120 Howard and One Sansome streets. Each of these assets was underwritten at approximately $450 to $500 per rentable square foot or approximately in the mid-$50s per square foot in annual rental rates.
The volume of sales transactions during the past few years has created many new San Francisco landlords who are beholden to high lease rate underwriting and reassessed taxes. Aggressive underwriting may necessitate rental rate increases of up to 30 percent, which will have a tremendous effect on occupiers. Tenants are likely to become extremely cautious when evaluating expansion scenarios. High rental rates, coupled with excessive construction costs, may prohibit companies from moving to new space. Sublease activity may proliferate as companies with extra space seek to remove lease obligations off balance sheets and profit from the high rental rates their unused office space may command. San Francisco Class A office asking rental rates have been rising since 2004, and this trend should continue.
— Nick Slonek is senior vice president and sales manager in Cornish & Carey Commercial’s San Francisco office.
Seattle
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Seattle’s CBD office vacancy rate falling below 10 percent for the first time since early 2001 has led to a construction boom.
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With vacancy declining rapidly in the CBD and rents on the increase, downtown Seattle is finally seeing the office construction boom that is already in full swing in the suburban Bellevue market.
Seattle’s CBD vacancy rate has dropped below 10 percent for the first time since early 2001 and will continue to decline as job growth in the Puget Sound region remains strong. Class A and B asking rates have risen significantly in the past year; Class A asking rents are approaching $30 per square foot for the first time since mid-2002, and Class B rates are at a 5-year high. Net absorption in Seattle’s CBD at year-end 2006 totaled more than 1 million square feet for the first time since the waning days of the technology boom in 2000.
In early 2006, sweeping zoning changes in Seattle’s downtown core were adopted to encourage high-rise development. This, coupled with the improved health of the office market, encouraged development to kick off in earnest in late 2006. A number of major projects have begun construction or are planned to start in 2007. By the end of this year, more than 2 million square feet of new office space could be under construction.
Major projects include Touchstone Development’s West 8th (483,000 square feet), Vulcan’s 2201 Westlake (302,000 square feet), Group Health headquarters (278,000 square feet), Schnitzer Northwest’s 818 Stewart (230,000 square feet) and Martin Selig’s 333 Elliot (137,000 square feet). At this point, only the Group Health Headquarters and 333 Elliot projects are significantly pre-leased. It remains to be seen what tenants will take up the new space, but local developers are betting that demand will remain high and a number of large users waiting in the wings will absorb significant chunks.
— Nick Papa is the research manager in Grubb & Ellis Company’s Seattle office.
Salt Lake City
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Downtown Salt Lake City’s office sector remains steady now, but a $1 billion investment in the area during the next 4 years will speed things up.
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What impact does a $1 billion investment in the CBD have on a market? Salt Lake City is about to find out. City Creek Center, a primarily residential and retail redevelopment currently underway, encompasses approximately 20 prime acres of Salt Lake’s CBD. Property Reserve Inc. and several key partners have begun work on the new development scheduled for completion in 2011.
Although there’s a lot of buzz about the long-term impact of City Creek Center, the immediate impact on Salt Lake’s office market has been minimal. The current overall vacancy rate is hovering at a stable 11.18 percent, which does not represent a substantial change from the vacancy rate reported in the CBD last year. Similarly, asking lease rates have remained steady during the last year with Class A and B asking rates at approximately $21.50 and $16 per square foot gross, respectively. The most significant impact in both vacancy and lease rates was felt in the Class C sector, where vacancy has dropped a little over 10 percent to 14.28 percent. This decrease has allowed asking lease rates to increase around $1 per square foot, bringing them up to $15 per square foot gross.
Although it appears that lease rates for Class A and B space have reached a plateau, this trend is deceptive. Class A vacancy rates are now at 5.73 percent. Buildings that are considered to be on the lower end of the Class A scale are becoming the benefactors as a result of the lack of Class A space. Over the last quarter, lease rates in several of these buildings have increased by as much as 20 percent, which is significant in the Salt Lake market. Additionally, new Class A buildings slated for construction are having to charge rents in excess of $30 per square foot gross due to the increased cost of construction. Traditionally, office rents in Salt Lake’s CBD have hovered in the low to mid-$20 per-square-foot range. With more development of Class A office product to be delivered in the next several years, it appears that a new benchmark for office lease prices in Salt Lake will be set.
— Casey Mills is an office specialist for NAI Utah Commercial Real Estate in Salt Lake City.
Honolulu
During the past 3 years, nearly 10,000 new office positions have been added to Honolulu’s payrolls, mostly concentrated among the professional and business services component of the office sector. This rapid expansion of Honolulu’s workforce resulted in nearly 1 million square feet of occupancy in the past 4 years, the healthiest net absorption growth in the history of Honolulu’s office market.
Hawaii’s booming economy, fueled by strong residential home sales, robust construction activity and record air passenger arrivals, spurred rapid growth in the office market. Tight market conditions persisted as Honolulu’s CBD office vacancy fell to its lowest level — 6.67 percent — in more than a decade thanks to nearly 170,000 square feet of positive absorption recorded in 2006.
This rising demand pushed CBD office asking rental rates upward by more than 8 percent during the past year. The average full-service, gross asking rental rate rose from $2.27 per square foot per month to $2.46 in the past year. Among CBD Class A properties, full-service, gross asking rents jumped by 23 percent during the past 3 years from $2.32 to $2.85 per square foot.
The transition from a tenant-driven market to a landlord-controlled market has been finalized. Free rent, tenant-improvement allowances and other landlord concessions have been greatly reduced, further compounding the difficulties faced by tenants considering relocation or expansion.
Rising construction costs have reduced the likelihood of new office supply being added to this market. It is not uncommon to hear quotes of $300 to $350 per square foot for construction costs for high-rise office buildings. Office rents would have to more than double before it becomes financially viable for office construction to begin, and that is if construction costs and land prices remain at current levels. Without the threat of new supply, tenants have little negotiating leverage and few options when faced with landlord rental rate increases.
Despite the landlord’s strength in this market, several factors are likely to decelerate the rate of Honolulu’s office growth. The record 1.6 percent unemployment rate will result in an increased risk of wage inflation, which will likely reduce future hiring efforts, and Honolulu’s residential market slowdown may result in a reduction in workforces for real estate-related businesses.
— Mike Hamasu is director of consulting and research for Colliers Monroe Friedlander in Honolulu.
San Diego
While the anticipated completion of downtown San Diego’s second Class A high-rise in 2 years is expected to cause a slight up-tick in vacancy in 2007, the city’s CBD submarket is stable and poised for continuing escalations in lease rates.
A Burnham Real Estate report shows current CBD vacancy at 11.6 percent, a number that is expected to rise to the 12-percent range in 2007 with the second quarter completion of DiamondView Tower. The project, located adjacent to PETCO Park, is adding 150,680 square feet to the market, approximately half of which is already leased to tenants such as Cox Communications and Comerica Bank.
DiamondView follows the 2005 completion of Broadway 655, which now is 82 percent occupied. This tower is listed for sale with multiple investment groups underwriting the offering, which is expected to generate final pricing of more than $500 per square foot.
“DiamondView and Broadway 655 are the only new downtown San Diego high-rises in over 14 years; as a result, their completions have not significantly impacted vacancy,” says Jennifer Gallivan, associate vice president with Burnham Real Estate. “The addition of these premier towers, along with strong investor interest in the CBD, are pushing Class A lease rates to more than $3 per square foot. Average asking rents downtown are expected to increase 10 percent by 2008, rising from $2.60 to $2.86 per square foot.”
The Irvine Company, which has purchased six towers in downtown San Diego during the past 4 years and most recently acquired BOSA’s site for yet another new high-rise, expects to achieve $4 per square foot for premier space within the next 12 months.
Rising rental rates are prompting increased tenant movement to older and more affordably priced space such as 450 B Street, which is slated for extensive renovations.
“With the thousands of new residential units that have come online, downtown has also seen the advent of niche office condominium projects, such as TR Produce and MetroWork (both new construction) or Old City Hall and Columbia Court (conversions), which offer trendy, loft-style suites for sale,” says Gallivan. “These are a financially favorable way for businesses to invest in their location in a market that in general is viewed with long-term upside potential.”
— Sandra Grove
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