WESTERN SNAPSHOT, NOVEMBER 2007

Tucson, Arizona, Office Market

Gross

Although some new office development in Tucson has cooled somewhat due to higher costs, interest rates and impact fees, it seems to still be surging ahead in the county. The price of land continues to increase, due to supply, to where what was considered a good deal at $8 to $10 per square foot is now $11 to $14 and even as high as $18 per square foot.

The “grey shell” cost of new construction, which was at $150 per square foot 2 to 3 years ago, is now $185 to $210 per square foot. Including interior improvements, the total cost has soared to $240 per square foot and as much as $300 per square foot for some medical offices. Due to these costs, rental rates on new construction have risen to as high as $30 per square foot, including all operating expenses, real estate taxes and insurance. On newer projects, the rental rates are $21 to $27 per square foot, modified gross.

For seasoned projects as an investment sale, the purchase price has been all over the board depending on effective cash-on-cash returns after financing. On these purchases, if one can find them, cap rates have been in the 7-percent and 8-percent range, depending on the age, condition and income of the investment. The rental rates in these seasoned investments have increased simply due to the increases of the next tier discussed above. In older existing Class A buildings, the rental rates are $23 to $26 per square foot, full service, and $16.50 to $21 per square foot in Class B and C buildings.

Overall, Tucson’s positive absorption for the year was on track for approximately 300,000 to 350,000 square feet until it hit a little glitch when First Magnus, 15th largest mortgage lender in the country, closed its doors about 1 month ago, adding approximately 120,000 square feet to the equation.

Rental rates have remained stable with a slight increase or less owner concessions to where the effective rate to the landlord has increased. The overall market vacancy has decreased to approximately 10 percent from an about 11+ percent at the same time last year. Rental rates for the balance of 2007 will increase slightly due to higher construction and tenant-improvement costs; buildings have sold in the recent past at low cap rates and some older renovated buildings have come on line with higher rates thereby raising the rates ever so much for the lower classes.

With regard to the future, Tucson is now a big city, boasting a 1 million area population in the fastest growing state in the country. Because of that, more national and regional developers/users are coming to the market. Therefore, the tenant mix and quality of space will improve. Higher rents are here to stay, and the outlook for the office market remains healthy due to strong growth and lack of speculative building for now.

Cap rates on office investments are few and far in between. For buildings with generally “mom-and-pop” kind of tenants, as long as the building has been relatively stable in the recent past and has upside potential, the cap rates should be in the low to mid-8’s. For buildings with more national tenants, that again have been relatively stable in the recent past and have upside potential, the caps should be in the high 7’s to low 8’s. Larger investment prices have ranged between $4 million and $20 million.

For Class A buildings, the full-service rental rates per square foot should be $23 and up, the Class B buildings will be between $18.50 to $22 and the Class C buildings will be from $16 to $17.50 on an annual basis, although these rates should edge up a little as older projects are bought and aesthetically improved. These overall rates are also dependent on the term of the lease, the improvements and the tenant.

At the beginning of 2007, the vacancy factor for competitive office space was approximately 11.5 percent. By the end of 2007, the vacancy factor will be approximately 10 percent. With exception to the developments that are finishing up right now and some smaller medical developments that are in the works, not much new product is coming on line for at least 1 year.

Referencing the Class C properties as good long- or short-term investment properties, this kind of product is hard to find and two-fold patience is a must. In this case, patience is a virtue. You have to have the patience to find one and where the owner is willing to sell it and then the patience to improve it, whereby the value and future return will increase over time. This has been apparent in Tucson’s retail market for the past several years and is what will happen in the office market due to the lack of newer investment-grade product on the market. And because the smaller user has purchased smaller build-to-suits (2,000 to 7,000 square feet) due to larger Class A and B+ properties substantially increasing their rental rates in the past few years because of the projected pro-forma values those larger properties were purchased at, the competition has recently increased keeping the rental rates in these buildings relatively in check for the time being.

Michael A. Gross is an associate broker and office leasing and investment specialist for Tucson Realty & Trust Company/TCN Worldwide.

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