Philadelphia Developers Stay The Course To Avoid 'Talking Ourselves Into A Recession'

After a protracted recovery from the Great Recession, it seems that storm clouds are gathering on the horizon once again for the national economy.

Much has been made through the years of Philadelphia’s slow and steady nature, and the city stayed true to form by growing at a slower rate than New York and other gateway markets after the recession. What comes next is a test of the other half of that truism.

“We’ll definitely see some impact, some loss of jobs, but not as much as other cities will," JLL Research Director Lauren Gilchrist said. "And we could come out of the next downturn in an incredibly advantageous position due to the steps the city took to shore up its market in the past 10 years.”

Gilchrist will join Parkway Corp. Senior Vice President Brian Berson, Rubenstein Partners principal Stephen Card and Nightingale Properties Vice President Brenton Hutchinson and other leading Philly voices at Bisnow's Philadelphia State of Office event at the Bellevue Hotel Jan. 24. She noted that millennial in-migration spiked in 2009 and 2010 as people came seeking Philadelphia's lower cost of living and steadier jobs market.

“I’ve lived through the good times, the bad times, and now the good again [in Philadelphia]," Hutchinson said. "Philly is based on the 'Eds and Meds,' so unlike New York, D.C. and Boston, we’re not hit as hard by the dips or the gains.”

Some have estimated that a downturn is on the horizon and could hit as soon as next year, but a look at fundamentals in Philadelphia hardly gives any ominous indicators. CBRE's Q4 office report found that fundamentals "strengthened throughout 2018 with yet another quarter of growth, marking the conclusion of a historic year of occupancy gains in the region." The report projects office-using employment to continue increasing in 2019.

If Philadelphia's fundamentals remain as strong as they have been in the past few years, then it hardly gives one reason to worry. But a combination of headline-grabbing trends and actions have contributed to a loss of confidence, even if none of them directly involve real estate. In fact, the Federal Reserve signaling an intent to slow down interest rate hikes could be a net positive for commercial real estate, lowering the potential cost of capital. But the factors that led to the Fed's reversal of its earlier intentions remain in play.

“Beyond interest rates, there was so much macroeconomic instability heading into the end of the year due to the stock market, tariffs, the government shutdown and our erratic foreign policy that it gave a lot of participants pause,” Gilchrist said.

That loss of confidence, even if based on nothing tangible, can be enough to overwhelm the facts on the ground and send the market into contraction, according to Berson.

“I’m hoping that we’re not talking ourselves into a recession. We could be,” Berson said. “When we start asking ourselves if the recession comes tomorrow and everyone is talking about the same thing, then the recession does come tomorrow because everyone freezes up.”

Even if psychological factors are what trigger a downturn, Philadelphia doesn't have as far to fall as its neighboring markets. While Class-A rents have risen 20% to 30% in Philadelphia since 2010, the same subset of buildings has seen 100% increases in rent in New York, according to Card. 

Office construction has remained notably slower than in New York, D.C., Boston or any other markets considered more valuable than Philadelphia. Very little product built in the past decade was available when construction completed; certainly now, speculative construction is a financial nonstarter. That has led to a continuous game of musical chairs among the Class-A buildings in the central business district, Card, Berson, Hutchinson and Gilchrist agree.

The lack of construction, coupled with the competition for tenants, has led to a relatively aggressive market for CBD acquisitions and renovations to push rents marginally higher. Nightingale Properties has followed up its record acquisition of Centre Square by investing in something like a standard modernization package: improved lobbies, elevators and facilities, with a reimagined retail tenant roster on the ground floor and basement subway concourse, Hutchinson said.

The effect so far has been the retention of major tenants with expiring leases, along with some smaller gains, keeping occupancy above 90%.

Rubenstein's September purchase of the Lower Makefield Corporate Center in the southern portion of Bucks County fits the profile as well: improved public spaces, better amenities and, to match the suburban setting, a renewed focus on activating the outside of the building with walking trails and common areas. 

Rubenstein is approaching completion of similar improvements in the Wanamaker building, which Card said have boosted it into a value prospect within the Class-A tenant competition, rather than the priciest option of the A-minus/B-plus tier.

Nearly every recent buyer of office real estate in the Philadelphia area has invested meaningfully in its buildings, which has led Class-A rents setting per-square-foot records.

The game of musical chairs that has driven those rents has done little to boost occupancy numbers, and that is where the concern could be if the market goes south, according to Gilchrist. Card said Rubenstein's improvements are focused more on retaining and improving occupancy numbers rather than driving rents higher.

As tenants decide between remaining in place or moving offices, they have continuously looked for smaller spaces to match their designs for more dense floor plans. That has made up for the bulk of the pressure on absorption and vacancy numbers, which Gilchrist said have historically been addressed in Philadelphia by removing underperforming buildings from the market and converting them into multifamily buildings.

“My biggest concern for weakness in the potential market is that, barring any backfilling of potential space from new tenants, the South Broad Street corridor is looking to experience vacancy around 30%, which is huge,” Gilchrist said. CBRE estimates the total vacancy rate to be around 11% in Downtown Philadelphia.“That would either position that corridor for redevelopment or the last place you can do cheap office deals in Philly.”

Though a lack of new office construction may have protected Philadelphia from overexposure to a downturn, it also prevents it from having a fully modern stock of office buildings that could attract tenants from its more expensive neighbors.

Philadelphia may "pat itself on the back" for its conservative approach, Berson said, but volatile market swings and steady, linear growth both could even out over a long enough time period. A lower floor for contraction might be worth a higher ceiling for growth, in other words.

“I’m not sure that it’s a good thing; it does mean we’re insulated from big swings, but if we were the center of an industry like New York is for finance, D.C. is for government or Boston is for biotech, and that industry got hit, it would hurt," Berson said. "But it would ultimately be a good thing to be the center of an industry.”

Parkway Corp. is currently marketing several of its land holdings in Center City as potential build-to-suit development deals for the large office requirements on the market. Berson recognizes the prohibitive cost of renting in new construction, but he sees just as much capital ready to invest in the market as there has been in recent years.

“What gets dangerous is when the capital disappears like it did in 2009," Berson said. "If it does, then we’re all screwed."

Perhaps the biggest source of uncertainty as 2019 gets underway is the ongoing federal government shutdown. Though it has yet to have a major effect on office real estate, if it drags on for months, the effects could be unpredictable and far-reaching. Though panelists for the upcoming event disagree on how exposed Philadelphia would be if government office tenants stopped making rent, they all agreed that it is impossible to predict just how damaging a prolonged shutdown could be.

“It’s when uncertainty filters into the capital markets is the biggest concern for us," Card said. "We like buying into uncertainty when we’re confident about a building, but when that uncertainty extends into fear in the capital markets, that affects our ability to finance.”

“It’s widely known that the Environmental Protection Agency is out in the [leasing] market right now, and the shutdown has affected their ability to search for space,” Gilchrist said. “If we’re missing paychecks for hundreds of thousands [of] workers and missing rent from millions of square feet of office space, there will be an effect.”

“It’s not a big issue right now to us," Hutchinson said. "If it goes on indefinitely, it becomes a conversation.”

“Overall, it’s really the most about consumer confidence, that it’s another negative indicator that would help us talk ourselves into a recession," Berson said. "I’m not as worried about office space requirements ... It could certainly hurt where there are high concentrations of employees that are furloughed. If I’m an apartment owner right around where there’s a massive furlough, I’d be crapping my pants.”

You can listen to Gilchrist, Card, Berson and Hutchinson debate other nuances of the market at Bisnow's Philadelphia State of Office event at the Bellevue Hotel Jan. 24.