The Great Office & Industrial Evolution

By March 22, 2019 Office

A couple days ago I checked out the Office & Industrial Philadelphia Development Conference and took away observations of some interesting movement in the Philly commercial real estate market. The panel discussion began focusing on vacancy rates and trends in the Mid-Atlantic region from the perspectives of speakers in tax, law, leasing, and banking.

A Common Theme: Demand in Office Space Leases

There’s no question all participants agreed that tenants are interested in a sense of place. As seen in King of Prussia and other local vicinities, there is less than a 10% vacancy of Class A office space. What’s interesting is, the same isn’t the case of Class B in many suburban settings. This offers a prime opportunity for redevelopment and spec build to suit provisions to enhance appeal.

As a whole in the US, construction costs are through the roof. Philadelphia has found itself in a position of carrying NYC construction costs while also holding mid-west rental rates. This is where funding and loans come in. Interestingly enough, it’s the vacancy that heavily drives the train for better terms on borrowing based on existing leases in a building. Based on what other lease terms contain on average in a building, this will guide the terms of a new tenant’s agreement.

The Hot Topic of Opportunity Zones

The conversation drifted into a brainstorm of opportunity zones and what development people have been seeing with this as a goal. The excitement of the topic is justified, just slow to take off. Currently, there are 300 opportunity zones in PA and 170 in NJ, with 8700 nationwide. Since the census data that qualified these areas as opp zones is about 10 years old, some of the areas aren’t really down-trotted any longer. Currently, there are at least 5-6 issues that are being clarified by the IRS in order for tax codes to be transparent about the parameters of the tax benefits available.

Some of the top conversations are how to properly self-report and the time frames involved. With self-reporting, the question is “How do you show the results of your operation?” This can take on different forms for varying organizations. For the time frame clarification, this offers an interesting debate. In many instances, people have held property for 10 years and many times have a development strategy spanning 3-4 years. What is the proper time frame to receive tax benefit in both scenarios?

Unclear Details Needing Definition

Another unique example comes from construction bridge loan scenarios. If there is some equity and a refinance occurs, the question arises of how these funds still need to remain involved in opportunity zones to be valid for the incentive. Many people believe funds just need to trickle through the fund—but when? This timing can’t be clearly said at this point. Time and further regulation will tell.

So, what’s in store for the future? At this point, lenders are much more comfortable with office assets. One interesting thought is we don’t know what type of offices these will be. Suburban offices are just now coming off the “do not fly” list.

The Strength of the Market

It’s no secret the real estate/construction market has been healthy—everyone I’ve been talking to recently has been overwhelmingly busy. We can definitely anticipate this uptick to correct itself, but the speakers agreed that an Armageddon isn’t likely. One speaker coined the typical transition people assume in this market position. “Innovators, Imitators, then Idiots.” First, come people with a great idea. Next, come some nice iterations of the same. Then, after time things become pretty diluted.

Right now in Philly, it’s a landlord’s market with pockets of contrast. In the case of landlords having an advantage, they don’t need to offer as much to tenants, as the options are limited out there. With less vacancy comes more demand for their offering.

An interesting correlation in Philadelphia was seen when ample Class B offices weren’t in demand, they converted them into apartments, and people were forced to go to Class A buildings because of their supply. From that point, Class B spaces could lease at comparable rates as Class A.

Philly Commercial Real Estate as we know it

The speakers mentioned how years ago, zoning was very segregated. Now, people seek a “town center” type setting, which was unheard of previously. Instant gratification is a big factor. People’s favorite stores, offices, and work all in one place has led to the “sense of place” people are after.

Although tax reform will produce a lot of much-needed clarity on investment activity in our area, talent and technology will continue to change the way we use space. While the concept of opportunity zones is pretty alluring, it’s important to remember that it’s a bad choice to do a deal solely for the tax benefits—especially when they aren’t perfectly clear yet.

Thanks to the Mid-Atlantic Real Estate Journal for hosting a really thought-provoking discussion. Philly’s commercial real estate always opens itself up to some interesting conversation.