COVER STORY, AUGUST 2004

DEVELOPING RE-FLEXES
Western office/industrial space shows flexibility in post-growth market.
Eric Haskins, Mark Krison, Oliver Fleener, Amado Martinez and Steve Kapp

Divide and prosper could best describe the developer focus in the West’s office/industrial flex market. What was a booming sector in the late 1990s took a major hit as its technology tenants, especially in Northern California and the Pacific Northwest, struggled during the most recent economic downturn. Now, owners and developers are appealing to the smaller, more active tenants by dividing and retrofitting old spaces or building new, less bulky product. The following details how flex(ible) space in this office/industrial market means divisible space.

Southern California

The most recent trend in developing office/flex space has been the move toward smaller product, especially small buildings for sale. This trend has been evident for the past 18 months and shows no signs of slowing down. In the past, flex space has been geared toward larger users, but there was a shift in the market as interest rates reached historic lows. Now small business owners that lease are in a position to purchase and developers have responded to that demand. The majority of small-building-for-sale projects are in the 3,000- to 15,000-square-foot range.

Werdin Corporation’s Pacific Business Center in Tustin, California, will offer 11 small flex-space buildings, ranging in size from 4,300 to 6,500 square feet. Seven of the buildings have already been sold before completion of construction.

One example of this type of project is Pacific Business Center, a small-building project being developed by Werdin Corporation in Tustin, California. The product in this 11-building project will range in size from 4,300 to 6,500 square feet. Demand has been such that seven of the buildings have been sold before the completion of construction.

This trend toward smaller flex product has been most prevalent in Orange County, particularly the southern part where there is available land. Other Southern California markets that are home to this type of product include the western San Gabriel Valley, the northern San Fernando Valley, the Conejo Valley and Corona.

Despite the trend toward smaller product, larger facilities are still sought after by certain types of users, especially bio-medical and bio-tech firms. Markets with a high concentration of these types of firms include the Santa Clarita Valley and San Diego. In fact, bio-tech users are driving the first new R&D development in San Diego in 4 years. Biosite is developing the first phase of its new corporate headquarters (350,000 square feet) in Fenton Technology Park in San Diego’s Sorrento Mesa area. Also, Biogen Idec is building a 167,000-square-foot R&D building next to its office building in North University City.

Facility design for the smaller product has been focused on buildings with three-to-one parking and 50 percent office build-out or less. Other features in demand include surface parking, a campus-like setting, high-speed communication access, and nearby restaurants and other retail services. The buyer profile for these properties is typically a well-established private/small company that has been leasing for quite some time. Types of users typically include engineering firms, import/export companies and light manufacturing companies. These buyers are being drawn to the opportunity to purchase their own space by the combination of low interest rates and readily available SBA financing. Lenders have also accommodated increased demand by small property users — and in turn stimulated further demand — by creating a large array of lending options. This is due in part to increased competition in the lending industry.

The small-building-for-sale trend has remained strong. Slight increases in interest rates have not slowed demand for the product. However, price per square foot pricing has probably reached its peak and will remain at its current level. In Orange County, that price would be $200 to $250 per square foot. Developers are becoming more cautious as interest rates begin to inch upward, and real estate professionals look for the small buildings for sale trend to begin to slow. However, the trend is expected to continue until SBA and conventional long-term interest rates escalate to a point that makes leasing a more favorable option.

— Oliver Fleener is a senior vice president and Amado Martinez is a research analyst in Grubb & Ellis’ Newport Beach, California, office.

Portland

Class A flex space, as a product type, emerged in the Portland marketplace about a decade ago and is concentrated in the west side suburban submarkets. It developed in response to the need for suburban “value office” and was generally designed as a single-tenant, concrete tilt-up facility for users in the 30,000- to 100,000-square-foot range. The buildings did not have any lobbies or common areas, and tenants were able to get nicely finished office space for a reasonable rental rate. With plenty of these users in the mid- to late ‘90s, development of this product type was brisk.

More than 5 million square feet of Class A flex was built between 1998 and 2001. At the end of 2000 the vacancy rate was just 7.2 percent. The vacancy rate in the Class A flex market now exceeds 23.5 percent, down from a high of 27 percent at the end of 2002. Many of the companies that occupied these buildings are now gone and a good number of the buildings sit vacant. While there is no new development of flex space to speak of, and none on the horizon, there is activity in the flex marketplace. The current trend is for owners of these empty buildings to retrofit the facilities to meet the needs of the tenants. Most of the market activity during the last 18 months has been with smaller tenants (3,000 to 9,000 square feet), who want “value office” space in a well-designed development with significant neighborhood and park amenities. Two specific examples of this trend can be found in the 217 submarket and in the Sunset Corridor.

The nearly 600,000-square-foot Creekside Corporate Park in the 217 Corridor has several buildings that illustrate these changing market dynamics. The park’s owner, PS Business Parks, found itself with four empty flex buildings. The buildings were designed to accommodate a single user with flex/manufacturing space on the ground floor and office on the second floor. PS took a proactive approach to addressing this vacancy and the needs in the marketplace of smaller tenants who wanted 100 percent office space with value and quality. PS converted the empty flex buildings to office by adding a building lobby with Class A finishes, elevators and drop ceilings. With these modifications, the buildings were divisible into smaller suites and PS has been able to capture tenants in the marketplace with value office rates of $16.50 FSG (?).

In the Sunset Corridor, the 1.4 million-square-foot AmberGlen Business Center will take a slightly different approach to a similar issue. Most of the flex buildings developed in the late ‘90s in this submarket were designed for single tenants with 90- to 100-foot bay depths. This makes the buildings impossible to subdivide into suites smaller than 5,000 square feet. AmberGlen’s developer, Birtcher Commercial Development, plans to insert a lobby and put a corridor down the center of the buildings, making them divisible to suites from 2,000 to 10,000 square feet. The buildings will accomodate the needs of the types of tenants that are currently thriving on this side of Portland — ranging from small semi-conductor sales offices to residential mortgage brokerage firms.

— Eric Haskins works in the Office Services Group in Grubb & Ellis’ Portland office.

Phoenix

One of the most interesting things about office/flex industrial product in the metropolitan Phoenix market is how much this product type has grown.

Six years ago the office/flex industrial segment almost didn’t exist. Now, there is a base of approximately 11.5 million square feet in and around the Phoenix metro area. This growth can be attributed primarily to the high-tech boom of the late 1990s.

Companies such as Motorola and Avnet were the original office/flex industrial tenants, using the buildings to house research and development (R&D) teams and computer chip assembly workers. Today, the spaces are often occupied by call and data center operations, healthcare companies, and high-end light manufacturing firms requiring fully air-conditioned environments.

As the flex product type has evolved, so have several trends, including:

• A greater need for parking. Landlords and users are packing more people into available building space, forcing parking ratios to grow from 4/1,000 to 6/1,000.

• The opportunity to go vertical. Newer buildings are being designed with mezzanine capabilities.

• Redundant power. Data centers in particular are requesting that two or even three power substations service a single location, and some are requiring battery power as a back-up source.

As the name implies, flexibility is key in designing office/flex industrial buildings. They need to accommodate users ranging from traditional office to light manufacturing or possibly even both in the same structure. Buildings typically range in size from 30,000 to 80,000 square feet, and have a greater clear height than a typical office building. To accommodate the loading requirements of manufacturing users, these properties are usually built at grade, but have truck-well capabilities.

In the Phoenix area, much of the office/flex industrial product is being developed by a few key players, including the Douglas Allred Company, Ryan Companies and SunCor Development. A number of smaller developers make up the rest of the market.

Allred Cotton Center features nearly 1 million square feet of flex, office-industrial and R&D space in Phoenix.

Allred Cotton Center is perhaps one of the best-known office/flex industrial developments in Phoenix. Located within the 280-acre Cotton Center master-planned business community, near 40th Street and Broadway Road, Allred Cotton Center features nearly 1 million square feet of flex, office-industrial and R&D space. Plans call for the project to include 12 buildings ranging in size from 21,000 to nearly 110,000 square feet. The project developer, Douglas Allred Company of San Diego, recently purchased 22 additional acres for expansion. Major tenants at Allred include Progressive Insurance, operating a 165,000-square-foot call center; Wells Fargo Home Mortgage, operating a 26,593-square-foot call center; and Caremark, which runs a 79,734-square-foot service/prescription drug distribution center.

Chandler Freeways Business Park, located south of Chandler Boulevard along the Loop 202 Freeway in the Phoenix suburb of Chandler, is under development by Ryan Companies. Nine buildings ranging in size from 31,500 to 165,000 square feet are planned, with the first three already completed. Build-to-suit opportunities are also available. The major tenant at Chandler Freeways Business Park is Verizon Wireless, which operates a 165,000-square-foot customer service/data center at the site.

One of the newest office/flex industrial projects in the metro Phoenix area is Rio West Business Park. SunCor recently purchased 25 acres at the southwest corner of Rio Salado Parkway and Priest Drive to develop a 300,000-square-foot business park in five buildings. Groundbreaking for Phase I began in July.

— Mark Krison is a senior vice president at CB Richard Ellis in Phoenix.

San Francisco Bay Area

Since the dot-com bust 3 years ago, new office/flex development has virtually come to a halt in the San Francisco Bay area. Current rental rates do not justify new construction for the foreseeable future. Rents have declined for the last 14 quarters, while construction costs have continued to rise, especially for lumber, steel, and labor. At the same time, land prices have remained steady.

Demand for R&D and office-flex products has been very light in the last 3 years, but is finally seeing some “light at the end of the tunnel.” Even though there have been no real notable improvements in this sector in terms of market statistics, the stabilization of both vacancy and asking rates suggest that the market’s bottom has been reached. Also, sublease space is diminishing. Because large technology firms are still underutilizing their real estate, these types have been largely absent in the market. The demand is being lead by small- and mid-size firms.

On the supply front, there is an overabundance of space, but, for the true Class A-view-type spaces, there seems to be strong demand. Vacancy has peaked at 22.6 percent, while sublease spaces have diminished to roughly 33 percent of total availability.

The current trend in flex space design is moving away from the large floorplate, “tech assembly” type facilities and toward smaller bay depth buildings. The need for large spaces, which once facilitated assembly, manufacturing and shipping channels, has been replaced with buildings divisible into 5,000- to 10,000-square-foot units with more glass lines, higher parking ratios and larger office buildout. Traditional R&D tenants are gravitating more toward suburban office product as the demand has shifted to computer technology companies. Other trends in facility design include an increase in owner-user sales activity fueled by low interest rates and lease-versus-buy models that favor building purchases; a rise in flex condo sales; and infill/rehab activity, paving the way for more functional flex product.

Characterized by owner/user sales, the East Bay R&D market has begun to show some indication of a market turnaround. Negative net absorption is declining rapidly as sublease space is being absorbed and new construction has ceased. While the R&D segment is the hardest hit product type in the I-80/880 Corridor, not all submarkets are experiencing the same challenges. In Hayward and Union City, California, significant biotech activity will create more stability, while Fremont, California, will be driven primarily by electronic and software uses. The different flex uses in the different submarkets mean variable rates of absorption, with pricing stability possibly several quarters away. It appears that activity levels are heading in a positive direction, and even minor backfilling of Fremont sublease space, coupled with renewal activity, will have a positive effect.

In Santa Clara County, there is more creative reuse activity, blending of rates with lease extension and leasing of sublease space. At the close of 2003, a number of major corporations came off the sidelines feeling that the market had finally hit bottom. However, with vacancy at 23 percent in the R&D market, the recovery to a single-digit vacancy may still take a while. This market segment has not only been dormant but also responsible for a large block of sublease space. The next 12 to 18 months will be affected by phantom space, which will diminish demand for new space as tenants use their surplus square footage. Simultaneously, pent-up demand will create a surge; the two combined will likely offset each other. Large companies may withdraw sublease space from the market, and owner-user demand will remain strong as long as interest rates remain low.

San Mateo County is identified mostly by its biotech/life science tenant base. Since the dot-com bust in early 2001, these types of companies have unloaded an abundance of sublease space into the market. In an odd twist, this sublease space is actually fueling the growth of new biotech companies. The sublease spaces will provide lower rents, shorter-term leases and easier scrutiny of financials. In short, this offers flexible and inviting market opportunities for young companies.

— Steve Kapp is a partner at BT Commercial Real Estate/NAI in Oakland, California.

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