COVER STORY, APRIL 2008

STANDING TALL
Strong office activity in the downtown cores of many western cities still makes them the centers of attention.
compiled by Brian A. Lee

With impressive job growth in some western cities and dynamic downtown projects stimulating office construction in others, things are looking up in western central business districts (CBD). Office broker experts and executives took Western Real Estate Business downtown for an editorial tour of these high-profile office submarkets.

Los Angeles

Downtown Los Angeles' resurgence includes the CBD office submarket.

In 2007, the resurgence of downtown Los Angeles as a vibrant cultural and economic center continued its slow but unmistakable progression from fantasy to reality. A proliferation of hip new restaurants and nightspots, a highly anticipated Ralph’s supermarket and the state-of-the-art Nokia Theatre were all added to the mix last year, as were an oversupply of freshly converted lofts, high-end condos and apartment units. All of this activity in the CBD has been a boon for the office market, making the last quarter of 2007 one of the best yet, with absorption levels that outpaced other submarkets, including the TriCities and San Fernando Valley. The vacancy rate for downtown L.A.’s office market, once hovering hopelessly close to 20 percent, began 2008 at about 12.6 percent, with rents also seeing highs of $40 per square foot, full service gross.

But like the rest of the country, downtown Los Angeles must contend with the reverberating effects of the subprime mortgage fallout and credit crunch, amid nerve-wracking projections of worse economic times yet to come. The downtown office sector still relies heavily on the now-vulnerable financial sector, but is diversifying its tenant base of late with design architecture firms and advertising and entertainment companies. Downtown has secured a significant foothold in attracting these tenants from the expensive west side of Los Angeles, who are evaluating relocation as a way to reduce occupancy costs. With this critical mass of activity underway, the downtown’s office submarket is ready to weather the storm.

— Jonathan Larsen is executive managing director in Transwestern’s Los Angeles office.

Seattle

As anticipated, the 2007 Seattle CBD submarket could not match the monumental absorption numbers achieved in 2006 of almost 600,000 square feet of positive net absorption. That said, the CBD revealed a solid, albeit modest, 179,738 square feet of absorption in 2007 and ended the year with a vacancy rate of 9.18 percent. Major leases in peripheral submarkets, including Amazon.com’s 1.4 million square feet at a future Vulcan Real Estate development in South Lake Union and Microsoft’s lease-up of more than 1.3 million square feet in Bellevue, ensured that the area posted strong lease activity.

Although recession has become a buzzword in other parts of the country since the beginning of the year, downtown Seattle’s real estate market has remained relatively isolated from the effects typically associated with a slowdown in the economy. While companies such as Washington Mutual and Macy’s, which both occupy sizable spaces in the CBD, have witnessed layoffs, most commercial real estate experts agree that downsizing in terms of physical space is unlikely in the upcoming months.

This is fortunate news for the numerous developers here that are currently in varying stages of new CBD developments, which will combine to bring more than 2 million square feet online in the next 3 years. Major projects include Schnitzer West’s 750,000-square-foot M5 Commerce Center and Nitze-Stagen’s 760,000-square-foot Fifth & Columbia Building, both slated for completion in 2010.

The influx of new inventory will undoubtedly cause an increase in the CBD’s vacancy rate; however, asking rates for Class A space, currently averaging $35 per square foot per year, are not expected to fall.

— Dan Dahl is a senior vice president at Colliers International’s Seattle office.

San Francisco

The San Francisco office market is enjoying strength even as the national economy falters forces, a trend that is expected to continue through year’s end. Tenant demand for office space is being driven by the expanding information sector, which is forecast to add another 800 jobs this year. Growth of local tech firms is also generating increased construction activity. This year, more than half of the metro’s scheduled new supply will come online in the Financial District. Pre-leasing activity in the area has been strong, and vacancy in the submarket is expected to remain near the metro average, allowing owners to implement healthy rents gains this year. This year, sales activity could moderate somewhat due to tighter underwriting, despite some of the strongest fundamentals in the country and elevated investor demand. Cap rates edged lower in 2007 but are expected to level off in the mid-5 to low-6 percent range this year. Buyers may find properties with upside potential in the South of Market Area and Union Square submarkets. Rents have risen rapidly in surrounding submarkets, including the Financial District and South Beach, and some tenants who are priced out of properties there may move to less expensive areas nearby.

— Jeffrey Mishkin is the vice president and regional manager of the San Francisco office of Marcus & Millichap Real Estate Investment Services.

San Diego

Downtown San Diego has become a vibrant, mixed-use economy and is taking advantage of many positive areas of growth: an expanded convention center, more than 4,000 new hotel rooms, more than 10,000 new residential units, Petco Park (the San Diego Padres’ state-of-the-art baseball stadium) and the Historic Gaslamp District, which comprises more than 100 restaurants.

The downtown San Diego office market is San Diego County’s largest submarket, weighing in at more than 9.5 million square feet. As the county’s government and financial center, tenants are drawn to the area for the proximity to the San Diego International Airport; federal, state and local courthouses; and the many choices for public transportation.

The past 2 years have seen two new Class A office high-rises built, totaling almost 700,000 square feet. This is the first new office development in more than 15 years. Nearly 90 percent of this new space has been absorbed as the market was eagerly awaiting quality choices for growing tenants that wanted to upgrade their office facilities.

The vacancy rate at year-end 2007 dipped to 11.8 percent as net absorption for the year was a robust 215,374 square feet. Average asking rental rates for Class A space have increased 24.5 percent since year-end 2004 to an annual rate of $37.20 per square foot, fully serviced.

The outlook for 2008 is cautious as the economy has slowed and the market in downtown San Diego will be relatively flat for the year, but no major vacancy swings are anticipated. The mantra for 2008 will be about renewing existing tenants as occupancy levels move to the forefront of building owners’ minds.

— Frank Wright is a broker specializing in office sales and leasing for the Grubb & Ellis|BRE Commercial UTC office in San Diego.

Phoenix

Phoenix's CBD will welcome much-needed office space supply.

Phoenix’s central business district (CBD), where the current office vacancy rate of 12.3 percent is lower than the Valley of the Sun average, is about to welcome much-needed supply as developers have broken ground on three significant office developments. Mesirow Stein is developing Central Park East, a 448,000-square-foot, 24-floor office tower that is expected to be completed in 2009. Grace Court Buildings II and IV, comprising four- and five-story office buildings totaling 245,845 square feet, will attract lobbyists, government entities and other office users who are looking for new construction quality at a value. The largest of the three projects at 525,000 square feet is CityScape by Red Development. The 27-floor office building is part of a larger mixed-use project, which will also feature retail and residential space. This Class A tower will appeal to law firms and banks looking for image-driven space and access to amenities. CityScape and Central Park East, both LEED-certified, are changing the definition of Class A office product and are driving rates upward in a submarket where the current asking rent is a healthy $29.77 per square foot.

Office development in Phoenix’s CBD is keeping pace with projects like the ASU Downtown Campus, TGen Life Science Campus, convention center, new hotels and the Metro light-rail system, all of which are bringing a vital energy to the submarket and driving overall demand for office space.

— Tyler T. Wilson is a broker in the Office Group in Grubb & Ellis|BRE Commercial LLC’s Phoenix office.

Salt Lake City

Class A office product in Salt Lake City's CBD is in high demand.

The Salt Lake City office market continues to show positive net absorption and a sustained demand for product. Developers and the capital markets have not been over-zealous by creating a large supply of speculative office product. Most of the new office construction has had substantial pre-leasing activity.

The Gateway in the downtown area of Salt Lake City continues to have an impact on the office market. Large and notable companies, such as Fidelity and Ernst & Young, continue to locate in this mixed-use project. Tenants seek to have amenities such as restaurants, shopping, entertainment, condos and light -rail transportation at their doorstep. This project will continue to be the pace-setter in office development with little, if any, vacancy.

The central business district is very tight with Class A product experiencing a very low vacancy rate of 5.59 percent, giving tenants little choice when searching for office space. New Class A office development in the downtown area, such as 222 South Main, Gateway 5 and Metro West, should be a welcome opportunity for tenants. Class C properties tend to have the largest vacancy in all submarkets. The northwest submarket by Salt Lake International Airport tends to lag behind the other areas. Overall vacancy in Salt Lake County is about 11 percent and around 1 percent in sublease vacancy.

— Barbara Johnson is an office specialist with NAI Utah Commercial Real Estate in Salt Lake City.

Denver

Office deliveries are expected to pick up in Denver this year, causing a short-term pause in the metro’s recovery cycle. Absorption has outpaced new construction in each of the past 4 years, resulting in a nearly 600 basis-point reduction since 2004. New construction will have the greatest impact in the Midtown and CBD submarkets, which are projected to receive more than half of the metro area’s completions in 2008, after less than 100,000 square feet came online last year.

A strong long-term economic outlook and healthy tenant demand will continue to lure investors to the Denver office market in 2008. Intensified scrutiny from lenders, however, could push up Class A cap rates from the mid-5 percent range, while Class B/C cap rates are expected to exceed 7.5 percent. Investors will continue to pay high premiums for newer assets in the northwest submarket, where population growth will support greater office-using demand in both the near and long term. While Class A properties will remain in high demand among cash-heavy institutional buyers, leveraged investors will focus on Class B/C assets, positioning their portfolios for an eventual upswing.

— Adam Christofferson is the vice president and regional manager of the Denver office of Marcus & Millichap Real Estate Investment Services.

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