Philadelphia office market is just now starting to reset, experts say
A view of Center City's central business district.
C. SMYTH FOR VISIT PHILADELPHIA
Three years since the start of the Covid-19 pandemic, Philadelphia’s office sector is just starting to experience a resetting of the market.
Since the average pre-pandemic office lease in Philadelphia was seven years, the reset is still in its early stages, CBRE Greater Philadelphia Market Leader Rija Beares said Wednesday at a Center City District panel event.
In 2019, Beares said Philadelphia offices had high rental rates and low vacancies. Business owners, then unsure what to do in 2020, committed to short-term extensions rather than long-term commitments. Thus Beares believes the office sector is only in the second year of a seven-year cycle.
“The first couple buildings that are going to go into receivership or go back to the lender, that’s starting to happen now,” Beares said. “And what happens when that occurs is that you have the reset of value.”
In the fourth quarter of 2022, Center City office vacancy increased to 18.6%, according to Center City District's State of Center City report released Wednesday. By February, the volume of individuals in Philadelphia’s office district increased to 47% of 2019 totals, with peaks on Tuesdays, Wednesdays and Thursdays.
Companies with expiring leases in recent years have opted to downsize to 50% to 75% of their footprint, but are leasing higher quality space. Thus the flight to quality trend has remained strong. The combination of less space in a better building results in companies spending the same amount of money on rent, Beares said.
JLL Philadelphia Office Co-Head Ryan Ade said what happens to Class B space that tenants are leaving is a “big question mark” for the office market. While demand for trophy and Class A space has been high, Class B buildings face a more uncertain future.
“The landlords that invest their capital in their space, that make office a place you want to go to, that draws in workers from a collaborative standpoint, and also from an amenity standpoint, are going to be the winners at the end of the day,” Ade said.
Panelists speak during an event at Vue on 50 in the Three Logan Square building following the release of the Center City District's State of Center City report.
CENTER CITY DISTRICT
The vacancy rate of office space in Philadelphia's central business district was 16.8% for Class A space and 17.4% for Class B space at the end of the first quarter, according to JLL.
Ade said he expects office sales in the near future to dictate the resetting of the market. The price could also help establish whether it’s feasible for new owners to convert the buildings into other uses. At 1701 Market St. for example, where law firm Morgan Lewis & Bockius is fully vacating later this year, a sale to Alterra Property Group for a planned conversion to residential fell through this winter.
“The question becomes does it reset to a level where it’s just amazingly low so you can just offer rents that are super attractive and just keep it as office and you can revive it in office that way?” Ade said. “It’ll be interesting to see if that plays out. I don’t know. … I think everybody wants to see what happens with those deals.”
Philadelphia has also bucked national trends regarding which sectors are returning to office. Beares pointed to insurance company Chubb, which will lease the entire 438,000-square-foot office building under construction at 20th and Arch streets. Throughout the country, insurance companies have been slower to return, she said. Meanwhile, Comcast has brought workers back to the office three days a week despite technology companies being among the slowest to return on a national level.
Beares also cited a report from consulting firm Accenture that says 63% of high-growth companies use a hybrid office model and 70% of no- and low-growth companies are either fully remote or fully in person.
“Hybrid does appear to be the future,” Beares said.
As the future of office space is uncertain, Philadelphia has the advantage of being a leader in building conversions. In the last 25 years, more than 40 Center City office buildings have been converted into hospitality or residential uses. But the viability of conversions depends on a building’s geometry and if it makes sense financially.
Gianni Parente, a regional investment officer at EQT Exeter, said his company estimates an office-to-residential conversion costs about 75% of ground-up construction. If office rents dip below a certain amount, a conversion makes sense. But the cost of construction still creates a difficult formula. Resetting office values would then factor in as well.
Center City District CEO Paul Levy said Philadelphia’s zoning code lends itself to easier conversions. In a CMX zone, Levy said, a conversion from commercial office to residential is as of right. In New York and San Francisco, similar conversions would require a major approval process. "We’ve got flexibility built into our code that we really need to appreciate,” Levy said.