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Philadelphia pros create new uses for older space

Our second annual meeting of Philly's real estate leaders finds a city in rapid transition.

Editor's Note: It's been about a year since we last held a roundtable in Philadelphia, the city of Brotherly Love, but I wanted to find out what had changed in the local commercial real estate market. As the pace of change continues to accelerate throughout much of America, how is Philadelphia faring with its strong tourism economy and its high-tech and pharmaceutical industries?

We invited a few local real estate luminaries to join us for lunch atop The Pyramid Club in downtown Philadelphia for a wide-ranging discussion. Here is what they had to say.

NREI: How is Philadelphia's economic health today?

Greg Byrnes: First you've got to look at Pennsylvania. I've got to give the Rich administration credit, because I think he's done a good job in terms of tax cuts, workmen's compensation cuts and he's also doing a good job of marketing the state. I think that's helpful. His goal when he took office a few years ago was really to try to make the state competitive with our neighboring states, Delaware, New Jersey, to some extent Ohio and try not to lose jobs. We're finding when we're dealing with out of town prospects right now that we are competitive and it's not just on the tax issue, he's also a very proactive governor in terms of getting involved in projects. There's one right now that's probably pitting the Philadelphia area against Delaware called SAP Americas, and when you're dealing with that type of company, a high-tech, fast growth, German-based company with 2,000 jobs and 350,000 sq. ft. of office space, he has made numerous personal phone calls to them. And he gets involved not only from the incentive game, but he's also very adept at working utilities and other groups so that we put our best price forward and things of that nature.

So from that perspective, I think the state is starting to turnaround. It's made tremendous progress in the last two to three years and I think some of that is now coming to Philadelphia. We've got some key industries that I think are helping that growth. You take a look at a company like Vanguard which now has more than 4,000 employees in our area. They're projected to grow about 500 to 750 employees each year for the next five years. In terms of office space, that's 100,000 sq. ft. to 150,000 sq. ft. This year Bill Rouse is doing two buildings for them, and the projection is they are looking for another two buildings for next year. That's where we're seeing our growth with the financial service firms and with the healthcare companies. Another company in our region that's doing well and just built a 100,000 sq. ft. headquarters is Genesis Health Systems out in Kennett Square in Chester County. And it's not just in the office sector. We're seeing it in the industrial sector too. When we're seeing a plant being abandoned today, we're seeing it filled up fairly quickly. So I would say that right now we have a lot of good active prospects.

Richard Jones: Economically, Greg's right, you have to look at the state. It lags Delaware and New Jersey, but it's picking up. The whole region is looking better now in job formation. But of course we're coming from a low spot because this area lags the national economy and now Pennsylvania is lagging Delaware and New Jersey. Delaware's unemployment is probably about 3%. And the central part of Pennsylvania is down to that 3.5% to 4% unemployment. Harrisburg, Lancaster, those areas are very strong. Now that we're coming from a low performance base, '97 looks strong. Housing starts are up in this area. Philadelphia had positive job growth in 1996 that it hadn't had in a while. From an economic standpoint, this area is improving. It's got good city leadership and has good state leadership. I agree with you Greg, the city and the state both working together are more harmonious and taking advantage of the industries that are here and growing.

Byrnes: One of the major differences between this year and last year, I think (Mayor Ed) Rendell and the city's really put an emphasis now on Philadelphia becoming a fun city. In the last year they've started a new marketing campaign, a new group advertising for tourism. That's been important.

Walter D'Alessio: You're right. Everything you said focused on the city, the convention center, the Delaware riverfront resurgence and some of the flashier projects. If you look at the impact on the economic base, it's truly regional. The interesting thing is when you deal with tourism and the visitor business, people don't just come and go to one location, have one experience and leave. It also is becoming sort of a regional gathering point. The interesting thing about the Delaware riverfront is if you analyze the folks that are frequenting the new restaurants they're regional more than they are visitors.

NREI: How healthy is Center City? There seems to be a lot of redevelopment going on.

Joseph Coradino: It's healthier than it was. It's still the healthiest market in the region. The suburbs are significantly better off than we are. I think that's part of the story of our health. If you were to go out to the 'burbs right now and look for 100,000 sq. ft., you might find three properties in all of the regions. There's not a lot of negotiations on rents, and as a result for the first time, where we had the flight to suburbs as a result of rising costs in the city, we're finding that tenants are looking to the reverse of that, coming to the city in order to save dollars. The issue that seems to come up, most of the companies are looking at the quality of the labor pool.

David Binswanger: The other thing that's changed in the last year if you think about it is that excess inventory that we all kind of were looking at when we said, 'What are we going to do with Broad and Walnut street, what are we going to do with Six Penn Center, what are we going to do with the PSFS Building, what are we going to do with all of these buildings?', we now are getting answers to. Answers that make economic sense. From the office standpoint, it's created some interesting play because the days of there's a lot of space and if you can't go here you can go there are going away because we have literally gentrified some of the older buildings and found different kinds of uses for them. We've created new opportunities, and it means that for the moment we're in this kind of creative mindset where if you need space in the city and you need any kind of reasonable size space, it probably isn't economical now to build the big new mega-tower, so we're coming up with Six Penn Center opportunities, or the buildings you're looking at and saying, 'It could be an office building, it might be residential, it might be a hotel.' I don't ever remember that before.

All of those answers are starting to make economic sense and I don't remember any time that I've been around where we've really been able to look at a building in a multiple of ways and say, 'There's enough demand in the office market to consider doing this, there's enough demand in the residential market so that makes sense, and there's enough demand in the hotel market.'

Jones: Joe's right about the suburbs, how strong they are. Short term, the city is in very strong shape. Comparatively speaking to where it has been, it has vastly improved. If you look at the in-place space, the city is about 34.5 million sq. ft., the suburbs are about 29.5 million sq. ft. If you look at South Jersey, Center City and the suburbs, the suburbs are now about 55% of the space, which is a shift that's taken place in those markets with the suburbs growing at a more rapid pace. For the short term, you could say that things look good in all of the areas. The real question is does the city have a real opportunity. It has the biggest employment base. You don't have it in the suburbs, you don't have it in South Jersey. If that employment base can be educated, the public school system improves, and there's a lot of attention being paid to that, you can say there is an opportunity for this city and others to regain and stop some of the flow that's going out.

Coradino: I suspect you're starting to hear the same thing, that, 'It's not the real estate, it's not whether I pay $22 or $24 or $26,' it's 'Where's my workforce? Where do I get the people?'

D'Alessio: One of the interesting things about that and you all touched on it is, this business constantly changes. We ebb and flow between various areas of the suburbs, Center City and South Jersey and other markets that become hot markets and cool off again. What are the forces that cool them? You can see the forces taking place today in the northern and western suburbs. It is congestion and traffic and lifestyle issues and ability to attract quality people that are refusing to sit on the expressway or try to get through the congestion. People who live out that way (the suburbs) say, 'I don't want to do this.' And their kids, more importantly, forming the next wave of the laborforce, are saying, 'I'm not going to live that way. I don't want to mow a big lawn and I don't want to sit in a car waiting to get to the next light so I can get to the next light,' and finally to a destination for which you're paying too much rent in the first place. So it all swings back again, and it will come back again. In Center City right now, space is competitive. David (Rubenstein) knows more than anybody that it's priced right now, there's a great play in these buildings. You've got people seeing it that way. Our next generation of equity investments is probably going to be in Center City office buildings as compared to this year's hotels and suburban office buildings and last year's multifamily and the year before that industrial. It just keeps moving. The trick in this business is to be just anticipating these trends. Access by transportation and to a labor force will be critical. But with all that is going on, if you take out of the Center City equation mothballed buildings or conversion buildings and get down to what do we have to lease out there, there aren't any big blocks of Center City office space to rent.

Binswanger: There aren't two buildings that can take 200,000 sq. ft.

NREI: In Chicago, there is a problem now with more people reverse commuting against the tide of people trying to get out to the suburbs to go to work. If downtown is to come back, though, what will be the kickoff? In the 1980s it was Bill Rouse. Is there some magic event like a new highrise that will be the catalyst?

David Rubenstein: It's already coming back, especially compared to last year. The problem is you can't just come back because every city in the country is coming back. It's got to do a little better than come back, and a lot of that has to do with what the needs of corporations are. At the end of the day, a lot of the drivers are major corporations. What happens with major corporations is you have M&A action happening internationally, and you have to be the acquirer in the Philadelphia area, not the reverse. The CFX situation is negative in that respect, but Delaware National could be a positive. You just have to get lucky that way.

Binswanger: I would disagree with you a little bit. I think what we have seen is a change in the corporate structure of who is running Philadelphia. Traditionally we had banks, we had insurance companies, we had law firms and accounting firms. As you look at what has happened you're starting to see a transformation of what industries are really running the city. We have seen the Conrails, we have seen the pharmaceuticals being taken over, and we certainly have seen all of the banks taken over. But you start to see other companies like Vanguard, like Comcast, a lot of the health services industries like Genesis. We have a whole different group of people coming up and I think they're starting to make different decisions about Center City infrastructure, where they're going to start spending money, and you started to see I think some new corporate citizenship by some of these people that creates a whole new wave that we're just beginning.

So I think we're seeing a lot of companies change the whole way they're doing business which is going to be really important.

Rubenstein: I agree with all of that. At the end of the day, it's got to be some of the major corporations, even if it's new corporations, the kind of new big companies, that have got to drive this place. We still have to have the large companies, there's just too much space.

Jones: This is a very strong year for Center City residential. We have an operation that is one of the top two in the market, and I think this will be the best year we've ever had. There are a lot of young professionals who want to stay downtown. The prices are extremely attractive. If you could see the prices that are available in downtown Philadelphia, they are extraordinary. There's more fun in the city with Penn's Landing, the convention center, the hotels, the restaurants.

Binswanger: Now if we could just do something about the Phillies we'd be...

Coradino: I'm curious, David, you talked a little about the Conrail situation, because I do and I don't sleep, have you thought about Conrail, Raytheon Bell Atlantic, the trilogy if you will. What happens when Conrail pulls out and Raytheon gets smart and starts to market their space at realistic numbers, and Bell Atlantic makes a much bigger pull out. All of that could end up putting 1.5 million sq. ft. on the market?

Rubenstein: I think about it a lot.

Jones: It's going to happen.

D'Alessio: But Joe, it's been happening all the time. I've spent 35 years operating in this area, and it's been a consistent and constant worry about big block users of space and employers of people. But there is very little that anybody can do about the economics that force that change, change in ownership.

And I understand what you're saying about the leadership of large corporations, but you have to face the fact that nationally, there are not a whole lot of large corporations that are used to a leadership position. Things have changed, and you're looking much more to smaller, entrepreneurial firms for economic growth in Philadelphia and the suburbs as well. That's the dynamic in our marketplace. We are being marketed much more to smaller, closely held, very entrepreneurial firms, and if we're successful we'll do well in that kind of growth area. If we're not, they'll dissipate and find their way to another location which is hospitable and allows them to take tax credits or something else.

Binswanger: In some senses, we need that space. I don't mean 1.5 million sq. ft. all at once. You've got some people out in the marketplace today looking for 70,000 sq. ft., 100,000 sq. ft., 125,000 sq. ft. with not a lot of good options. If there's space available in a Bell Atlantic Tower, or if there is space in a Commerce Square, I think it creates in certain ways some advantages because it will keep the concept of, 'Let's build a new tower and really put a couple million sq. ft. back on the market' in check.

Corradino: Yes, you're right, it's nice to have some more space, but I don't think that we've hit equilibrium yet, that we've fully recovered to the point where it's good again.

Rubenstein: I would much rather it not happen.

Corradino: I am very concerned about what you're talking about, but I hope that the pricing reflects it. There's some buying today under $100 a sq. ft., and when you get normalized on the pricing, hopefully that's a little better than buying a two-story suburban office building for $170 a sq. ft.

NREI: How has increased capital impacted the market?

Corradino: I'm not so sure that the capital was there for developing. The capital is there for acquisition. Capital may even be there for renovation. I don't see development capital for downtown out there at all. It's just not there. We'd be kidding each other about that.

D'Alessio: Plus it's a much more disciplined market that we operate in today. The advent of the capital markets and the growth that's come out of that sector in real estate brings with it a great deal more discipline. It's different than the capital we had in the past. Now we follow REIT securities and investments in the marketplace. This is kind of an understated market that we operate in, a disciplined market on its own. But they won't make capital available for a Center City office building unless the market conditions are right. Today, it's a big group of folks now that looks more carefully at that kind of investment.

Rubenstein: The irony is that a lot of the downtown money is equity rather than more traditional money. We still don't have the traditional downtown equity people like pension funds. It's more the opportunity funds. The irony is that it's the constituents of the opportunity funds are the traditional pension funds. So, it's just a matter of time until people start to break out of the opportunity funds and start doing some downtown buying. But they're not right now as far as I know.

D'Alessio: I don't think they ever will again. It's easier for them to buy REIT securities, it's easier for them to buy CMBS bonds.

Jones: I think the technology era we're in is so pervasive and creeping throughout everything we do that capital is more liquid, it's more transient, companies are more transient. What Walt said about breaking up into pods, I think that will continue, so that you won't see a CoreStates building per se. You won't see as many, anyway, you might see one. You won't see major corporations taking a total building because some of them have operations that they can put somewhere else with a different profile employee.

NREI: We've talked a lot about the office market, but if the mayor's right and he has 30-some proposals for new hotels on his desk right now, what's happening in that market segment?

Corradino: In order for a hotel to be viable in Philadelphia right now it needs city money, there's not question about that. I think Rendell at one point said he could do seven deals.

D'Alessio: The way they'll do it is to put about 15% of the money in on a subordinated basis, and that plus the equity generates the 60% or there about of first mortgage that you can do in today's market, even with all the enthusiasm everybody has for the hotel industry.

Binswanger: But the interesting thing to me is the whole perspective of what Philadelphia should be in terms of tourism has changed, and that they're really focused on the fact that we should be a destination city. The statistics are that most people came to Philadelphia, stopped on the expressway, went to the Liberty Bell, and went back and forth from New York to Washington. And now with the convention center we've now realized that we've got a lot to offer and we could really change that into a true industry. I think that's what's motivating the city. I think the economics that the convention center has brought are continuing to show and that's why you're going to see not 30, but four or five new ones, and maybe six or seven or eight.

D'Alessio: The main thing it does is it smokes all of the ideas out of the bushes, and you get a lot of good ideas. The PSFS idea is great. It's a great location and a great use for the building. You couldn't find a better reuse for an important property. On the other hand, there are some of those offbeat locations that have come up as potential hotels. Now you can test the options carefully.

David Binswanger, President, Chesterton Binswanger; Greg Byrnes, Director - Economic Develop. Dept., PECO Energy Co.; Joseph Coradino, Executive Vice President, The Rubin Organization; Walter D'Alessio, President & CEO, Legg Mason Real Estate; J. Richard Jones, President & CEO, Jackson-Cross*Oncor; David Rubenstein, President, The Rubenstein Company.

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