Investment And Innovation Are Increasingly Defining Philly's Office Market

Although a familiar combination of factors continues to dampen the possibility of speculative office construction, Philadelphia’s national profile has risen, thanks to a steady influx of investors looking to buy into existing product.

Although the Philadelphia office market continues to boast strong fundamentals of occupancy, steady rent growth and net absorption, very little new construction has been built — and what is on the way, like the new Comcast tower, is with specific tenants already agreed to move in. In other words, the speculative office market has been all but nonexistent in Philadelphia.

The lone exception to this is JOSS Realty Partners’ building at 34 South 11th St, which founding partner Larry Botel said is leasing up at a healthy rate without any compromise in rent prices. But he was quick to point out that it isn’t indicative of a trend.

“When we looked at 12th and Market for a spec office building, we just couldn't get there,” Botel said.

The biggest stumbling block, as always, is construction costs. Brandywine Realty Trust’s George Hasenecz told attendees that they rival New York’s costs, but without producing close to the same rent prices.

Despite that stumbling block, or perhaps because of it, investment activity has never been stronger in the city.

“Just in Philadelphia alone, we saw $3B in transactions in 2016,” HFF’s Douglas Rodio said. “That’s 50% more than in 2015.”

That’s an impressive number for Philadelphia, but still way behind national flagship markets New York, DC and San Francisco. That fact alone should provide optimism that there’s room for more activity, especially since out-of-market investors are showing more interest.

“I expect to see a handful of new entries to the market, on both smaller deals and larger portfolio trades,” Rodio said. “There will be more transactions, although I doubt many will be of the size we saw in 2016.”

Philadelphia seems to be enticing more investors after its combination of strong fundamentals and relative newness to those fundamentals, with an assist from its name brand.

“Philadelphia’s still the fifth-largest city in the country, and one of the few European-influenced cities in the country,” Botel said. “Among East Coast cities, Philadelphia looks exactly like the traditional primary markets and fundamentally acts like one.”

Yet the top end of Philadelphia’s market remains significantly cheaper than the gateway cities of New York, Boston and DC. Hasenecz said that Brandywine’s strategy of owning the “best buildings” in each market is more attainable in Philly than its neighbors — and selling Philly buildings is making owners money like never before.

“We’ve never seen momentum in this market like we have now, even with constrained supply,” Hasenecz said.

“We can buy at prices where we can add value,” said Rubenstein Partners’ Stephen Card (above, left). “There’s not necessarily a frothy debt market for that, but we still like the fundamentals.”

That constrained supply may not be around for long, however. New research from JLL, released after the event, suggests that in the next three to four years, more than a million square feet of new office space will hit the market.

While none of them are purely speculative, most of the newly delivered or under-construction buildings are not close to fully leased. Expectations may have to be adjusted, but for now, investors are loving what’s happening in Philly.

“An office building can almost do nothing in certain cases and still [provide return on investment],” Card said.

Yet for many investors and developers, office buildings can’t afford to do nothing. The currently tight office market means that competition for tenants is fierce, and landlords need to set themselves apart by making their spaces appealing to modern companies and employees.

Society and business have changed dramatically in the last decade. The unprecedented mobility of technology means that for many, offices are no longer required to do one’s job, meaning offices need to do more to recruit employees, first to the company, and then to the office once hired.

“It’s a little bit how like when we took our kids to college,” said Francis Cauffman principal John Campbell. “They would form impressions based on what the campus looks like.”

“It’s not just about improving the quality of life [of employees],” said Jacobs national director Amy Manley. “But if you look at the best organizations, they do just that, because they’re building social capital.”

One of the most notable ways that employers have built social capital in Philadelphia has been GlaxoSmithKlein’s entirely open office in the Navy Yard. The looser feel mirrors the freedom employees already get from their mobile devices, and by many accounts has fostered a more collaborative, social work environment.

The look of new office space is changing to be more flexible, and not just because it looks cooler, although that’s certainly a factor. It’s also because of the razor-thin margins with which companies operate.

“We’re in a need environment, wherein companies are looking to shed space and shed people, so flexibility is paramount,” HOK principal Stephen Beacham said.

As companies prize flexibility, so too must office landlords — that means updates and added amenities, luxuries that not everybody can provide in their buildings. That, combined with the fact that construction costs mean that all new buildings are all but forced to be Class-A, means that a disparity is growing.

“The market will increasingly be about haves and have-nots,” said MRP Realty managing director Charley McGrath.

“You’re going to see a tale of two cities,” McGrath said later. “And that tale is going to be who has amenities and who’s easy to get to on transit lines.”

If the gap grows, that would leave an opportunity for investors to add value to fill it. Even with occupancy rates perhaps at risk, that could be the way for the office market in Philadelphia to remain strong.