COVER STORY, FEBRUARY 2010

MEAT IN THE MIDDLE?
Find out which of the West's downtown office markets are still facing lean times and which are bulking up.
compiled by Brian A. Lee

Is downtown Phoenix seeing RED? When will CBD (central business district) leasing catch back up with the mountain of recent development activity in the Mile High City? Is the CBD by the Bay still looking for the bottom? Thanks to broker experts across the region, these and many more downtown office questions are answered in this Western Real Estate Business CBD office report.

Phoenix 

PHOENIX WILL RISE AGAIN: new academic, convention and sports facilities, as well as RED Development's 1 million-square-foot CityScape project, bode well for the city's downtown office submarket.

Phoenix has a downtown office core of less than 7 million square feet — small compared to similarly sized metro areas — that is largely occupied by big financial institutions and law firms. When a new building is developed, existing users tend to move to the space, leaving behind an older building with vacant space to backfill. In the past few decades, backfilling the vacancy worked as banks and law firms grew, but in today’s climate this will prove to be much more difficult.

ASU’s new downtown campus has been a big driver for mixed uses. The growth and maturity of this downtown campus will improve the retail, housing and office demand. The University of Arizona’s new medical school, TGEN and other health- and life-science entities are driving the downtown healthcare sector. Expect to see new hospitals and several more R&D buildings downtown during the next several years.

Downtown Phoenix is host to the newly rebuilt and expanded Phoenix Convention Center, new Sheraton Hotel and stadiums for the Arizona Diamondbacks and Phoenix Suns. These venues, along with theaters, concerts and other cultural offerings, make downtown viable as an entertainment center.

The biggest project right now is RED Development’s CityScape, a 1 million-square-foot project in the core of downtown comprising a 53 percent pre-leased office tower (complete this quarter) and approximately 250,000 square feet of mostly pre-leased retail space that includes a grocery store, gym and several apparel and nightlife retailers. There is also a new boutique Kimpton Hotels property under construction, The Palomar. CityScape will bring a great new modern vibe to the downtown core.

Downtown Phoenix’s office vacancy rate is 21.2 percent, due to the new construction buildings that are delivering with a disproportionate amount of vacancy. The older, more established downtown buildings average 18 percent vacancy. Overall office vacancy in the city is 26 percent, so the downtown outperforms the metro area.

The downtown office rental rate is $25.60 per square foot for buildings exceeding 50,000 square feet, Class A and B only. This is $4 per square foot higher than the Phoenix metro rental rate of $21.75.

— Tyler Wilson is a vice president at Grubb & Ellis|BRE Commercial LLC.

Denver

As a whole, 2009 was a challenging year for Denver’s CBD. The large amount of new supply combined with minimal leasing activity contributed greatly to the submarket’s steady increases in vacancy. At year’s end, the CBD reported roughly 4.3 million square feet of direct vacancy or roughly 16.1 percent of submarket stock.

The current development cycle began during second quarter 2008 and marks the largest amount of development activity in more than 10 years. Since that time, roughly 1.8 million square feet of new construction (6.7 percent of current stock) has delivered in the CBD; as of year-end 2009, just more than 1 million square feet of the space remained vacant. The development cycle is nearing its end, with Westfield Development Company’s 1800 Larimer Street still under construction. Fortunately, this building is 75 percent pre-leased to Xcel Energy, minimizing the amount of additional space coming online with its completion during second quarter 2010. This construction influx has contributed to the marked increase in the overall vacancy rate, which began the decade at 5 percent and ended 2009 at 19.2 percent.

Despite the large amount of supply present in the CBD, fourth quarter reported several changes, including decreasing rental rates and increasing lease activity. Gross average asking rates dropped a staggering $1.48 per square foot quarter-over-quarter, ending the year at $26.69 per square foot for both Class A and B space, and will likely decrease further in 2010. The primary driver for this drop in lease rates is the lack of true tenant movement. While many tenants are utilizing the market to leverage more aggressive renewal transactions with their respective landlords, very few are actually pulling the trigger and relocating. Consequently, several landlords with available space are vigorously competing over fewer deals further driving down rental rates.

Policy Studies Inc., Blackhills Energy, Polsinelli Shughart and Kennedy, Childs & Fogg all executed transactions during the latter half of 2009 and were examples of tenants taking advantage of these aggressive market economics. Should the economy stabilize mid-year 2010, as many economists are predicting, this should mark the beginning of renewed lease activity within the CBD. With the development cycle coming to an end and a modest increase in tenant leasing activity, the New Year will likely be one of stabilization within the CBD.

— Bruce Dodge is managing director at Jones Lang LaSalle Americas Inc. in Denver.

San Francisco

Real estate views, but not values, remain scenic in San Francisco.

Landlords and tenants alike spent 2009 searching for the bottom of this economic decline. Unfortunately, as the year closed with increased vacancy rates, decreased rental rates and depressed property values, the search will likely continue well into 2010 for many of the submarkets.

The San Francisco office market recorded almost 367,000 square feet of negative net absorption in fourth quarter 2009, pushing the citywide vacancy rate to 14.8 percent — the highest in almost a decade. While leasing activity doubled in the second half of 2009, San Francisco recorded only 4.1 million square feet of gross leasing activity for the year compared to 4.4 million and 7.1 million square feet in 2008 and 2007, respectively.

The CBD submarket has been a relative highlight. Vacancy rates are hovering at 12.3 percent, and view spaces and Tier 1 Class A properties have seen the most activity due to a measurable flight to quality. In fact, the largest leases in 2009 were upgrades, including Del Monte (at One Maritime), Medivation (Hills Plaza), and Silicon Valley Bank and AT Kearny (555 Mission Street). As this trend continues into 2010, expect asking rates and concession packages in this segment of the market to stabilize.

Another metric to watch closely is the available sublease space in San Francisco. Currently just more than 2.1 million square feet, this figure spiked in the beginning of 2009, but has since decreased as companies upgrade to cheaper subleased downtown office space. For example, law firm Novak, Druce, Quigg LLP subleased Sequoia Capital’s top-floor space at Tishman Speyer’s 555 Mission Street for a significant discount.

As San Francisco’s unemployment rate dropped to 9.7 percent in November (from a 10.2 percent high in August), many are hoping that this is a harbinger of better things to come. Job growth is required to transform near-term defaults, foreclosures and loan work-outs into healthy and stable investments.

— Ryan Carmichael is a financial analyst and market research coordinator at Cornish & Carey Commercial.

Los Angeles

Downtown Los Angeles is weathering the current recession. A glimpse of the downtown’s recent history might conclude that the thousands of new residential units and more than a hundred new retailers would be the downfall of a submarket that was just beginning to find itself on stable ground after the recession of the early 1990s. The reality, however, is that while the residential market has slowed and many retail stores have yet to be filled, the office market in downtown is still relatively strong when compared to other submarkets in the region, which have seen substantial increases in vacancy, causing reductions in rental rates of 20 to 30 percent during the past 18 months.

There are a number of factors that have insulated the office market in downtown Los Angeles from the effects felt throughout the city and the nation in the past 2 years. First, offerings within L.A.’s downtown has increased tremendously during the past decade, with housing for employees, dozens of new retailers and a vibrant city life after hours, including new entertainment, restaurants and cultural destinations, many of which are located within walking distance from the CBD. Downtown has also not experienced any office building construction within the past 17 years, and more importantly, more than 3 million square feet of office space (nearly 10 percent of the office inventory) was permanently removed from the leasing market as buildings were either converted to residential use, demolished for new residential or civic development or purchased by governmental agencies such as the City of Los Angeles and LAUSD.

While there are many sublease opportunities downtown, most of these spaces are still occupied by companies that would maintain a smaller presence in the same market. Some landlords reduced rental rates by as much as 10 percent in 2009 to stay competitive, but many are leasing space at the same rents achieved in 2007 and continue to see increased annual rents from existing lease contracts. Investor interest remains strong, although there are very few buildings available for purchase. The investment market has stagnated across the region, as investors are no longer in a position where they need to buy and owners aren’t in a position where they need to sell. This may change as loans mature in the next few years, but for now, owners seem content with the performance of their downtown assets.

— Chris Runyen is senior managing director at Charles Dunn Company in downtown Los Angeles.

Honolulu

Job losses continue to mount as roughly 8,000 office positions were lost since December 2005. This contributed to a tripling in Honolulu County’s unemployment rate at 5.9 percent in October 2009, still well below the national unemployment rate of 10 percent. Economists contend that Honolulu’s economy appears unsteady as a recovery is tentatively forecast for the last half of the year.

The looming budget deficits for both the state, city and county governments pose greater concern for 2010 as additional layoffs and furloughs are projected to occur. Already 2,900 government positions have been lost during the past year. Revenue enhancement (i.e., tax increases) or cutbacks in services are on the table for discussion and will likely adversely affect the momentum towards a future recovery.

Comparatively speaking, Honolulu’s office market proved much more resilient than many U.S. mainland markets, and Hawaii’s capital city did not suffer from an adverse amount of speculative construction activity. The market transitioned from a strongly favored landlord’s market to that of one at market equilibrium. The CBD market posted its third consecutive year of negative net absorption as the vacancy rate rose to 10.56 percent, well below the third quarter 2009 national CBD office average of 14 percent.

For the first time in 7 years, the average full-service gross asking rent for Honolulu fell from $2.84 to $2.74 per square foot per month (a 3.5 percent decline) and net base rents fell from $1.69 to $1.61 per square foot per month (a 5 percent drop). Rents are projected to trend downward as demand for office space still remains tepid.

The forecast here is that by the end of third quarter 2010 the market will begin to stabilize as vacancy rates are likely to continue to rise throughout the year. Should the pace of improvement to air passenger arrival counts begin to mount and home sales rise the recovery to Honolulu’s economy should begin to boost occupancy and demand for office space by 2011.

— Sean Tadaki is a vice president, office services division, at Colliers Monroe Friedlander Inc. in Honolulu, and Mike Hamasu is the director of consulting and research there.

San Diego

The downtown San Diego office market started 2010 with rents lower than they have been in more than a decade. With recovery tied to jobs, improvement may not come until 2012. In the late 1990s, rents in downtown climbed past the $2 per square foot mark. Now they’re crossing the $2 threshold again, but in the wrong direction. Class A, premium-view, high-rise space is offered as low as $1.60 per square foot in one building. The vacancy rate for Class A, B and C office space is approximately 17 percent, and available space, including subleases, brings this number to 18 percent. Adding shadow space (excess leased space not yet listed for sublease) drives the vacancy rate higher. Asking rents run up to $3.27 per square foot, though most leases are signed at a fraction of that price. Lately, each lease signed is more favorable to a tenant than the one signed days or weeks before.

The Irvine Company owns half of San Diego’s downtown Class A office buildings. With a long-term hold strategy and generally no lender to please, they have the ability to do what it takes to get deals done and typically outperform the market. For other buildings, it’s lessee beware. Rental offsets to secure any tenant-improvement allowance and negotiation of a subordination non-disturbance agreement (SNDA) to protect against landlord default are highly recommended, but can be difficult to secure.

The most significant office lease of the past year was by Procopio, Cory, Hargreaves & Savitch, an approximately 240-person law firm. Procopio vacated its 40-year residence downtown and leased 100,000 square feet at Hines’ office tower across the street.

The latest new downtown office developments, DiamondView Tower and Advanced Equities Plaza, were completed in 2007 and 2005, respectively. Both Class A high-rises leased up quickly, but mostly drew existing downtown tenants so net absorption was minimal.

— Misty Moore is a vice president, tenant representation, at Jones Lang LaSalle.

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