Shaking off tech’s hard fall

It seems like only yesterday: Technology was such a driver of industries, a changer of the world order. Many felt the gravy train could not end. Well, it has. Now, the best office tenants are those with credit — good credit, that is.

The dot-com shakeout and economic downturn have had both negative and positive effects, said J. Michael Dow, president and CEO of New York-based CRESA Partners. “The Nasdaq meltdown led to increased merger activity, divestitures and dot-com collapses, which opened up significant sublet-space opportunities,” he said. “This phenomenon is expected to continue. For those in need of space, this is good news. But the corporate tenants hit hardest will need help disposing of surplus space.”

Dow also predicted a glacial office development pace nationwide as a result of the dot-com collapse. “The higher-risk brought on by the advent of New Economy companies is causing investors to look for a higher, stabilized front-end return,” he said. “As a result, new office development is expected to slow to a near standstill.”

Since investors are warning against too much development in the major U.S. markets, many projects that have yet to break ground probably will not in 2001, Dow said. In the end, this year’s development likely will be limited to projects that were either pre-approved in 2000 or preleased by a major tenant under aggressive terms, he added.

“Although the year 2000 was one of the most volatile in corporate real estate history, there is no sense that the rug will be pulled out from under us this year,” Dow concluded.

Suffice to say that not every office market has been slammed by technology’s fall. In fact, many markets are doing quite well, with or without a healthy technology base.

Amid the current upheaval in the corporate world, dot-com and otherwise, NREI decided to explore how several leading downtown office markets — Boston, Dallas, San Francisco and Washington, D.C. — are faring. Each has a unique story to tell.

Boston breaks out

Unquestionably, 2000 was good to Beantown.

Local CBD office rents grew by 31.3% in 2000 compared with year-end 1999, according to Jim Bostello, senior economist at Boston-based Torto Wheaton Research. The company’s statistics also show that rents in second-quarter 2000 grew 16% compared with second-quarter 1999. The growth rate had slowed by fourth-quarter 2000, as rents in that period grew 7.3% compared with fourth-quarter 1999.

Overall vacancies have not experienced a radical change in the past two years. And perhaps best of all, developers held off on many of their grander plans, with little building completed in Boston in the past three years.

Statistics from Boston-based Meredith & Grew note that fourth-quarter 2000 finished with a miniscule vacancy rate of 2.2%, while net absorption in 2000 totaled a healthy 1.47 million sq. ft., of which 482,809 sq. ft. was absorbed in the fourth quarter.

Still, no market is completely immune to prevailing national trends. “The tech slowdown has had a noticeable impact on both the Boston CBD and Cambridge submarkets,” said Maria Sicola, senior managing director of research and analysis at New York-based Cushman & Wakefield. “The CBD has seen a significant amount of sublease space, most of which is dot-com-related, returned to the market.” This has had an impact on Class-A rents, which were in the $70 to $80 per sq. ft. range at the end of 2000, and are now in the high-$60s to low-$70s range, Sicola said.

Although leasing activity has slowed as well, the good news is that a tenant’s market has yet to emerge. “A few large blocks of space are available, yet there are still relatively few options for large space users downtown,” said Sicola. CBD vacancy rates may have increased by 1% to 2% over year-end 2000, but the market is still one of the country’s tightest, Sicola added.

And while the rental rates may not make tenants scream with joy, the CBD does offer office space users such benefits as access to top-notch colleges and universities, and highly-educated employees. Also, “much of the sublease space now available in the market is offered at attractive 5- to 10-year terms,” Sicola said.

While rents in Boston’s suburbs may be comparatively less expensive than rates in the CBD, suburban rates have spiked significantly as well. Consequently, “CBD tenants, which have relatively little motivation for relocating, are not expected to flee for the suburbs,” Sicola said. “The tech slowdown and pending economic downturn are expected to affect both the CBD and suburban markets alike, keeping most tenants where they are.”

Certainly, 2001 promises continued change. “The year 2000 was spectacular by every measure but the lack of office supply resulted in a crisis,” said Robert Kasvinsky, vice president in the Boston office of Northbrook, Ill-based Grubb & Ellis. “Slower growth should bring a return to more normal and manageable conditions for tenants.”

Dallas draws on tradition

Dormant: That is the one-word description that comes most quickly to mind when describing Dallas’ CBD office market. Like so many urban settings across America, Dallas suffers from the lack of a true 24/7 downtown. All things considered, though, Downtown Dallas — chock-full of traditional tenants, including firms in the accounting, finance, consulting and oil/energy industries — does not seem to be losing too much ground.

Downtown’s A+ buildings are still popular, and all are around 95% occupied, according to Michael O’Hanlon, executive director of the Dallas/Fort Worth office of Insignia/ESG. “They’re renewing tenants, and, when space is available, they’re attracting new tenants,” he said. “These are the best tenants, with the best credit, in the best buildings.”

However, Dallas’ CBD has not been successful in luring traditional suburban tenants, even with its abundance of available space and attractive rents. “Although downtown has diversified over the past several years, it remains largely a 9-5 CBD, with a relatively small residential and supporting retail base,” said Sicola.

Many firms located in the CBD are looking to create satellite offices in the suburbs for a variety of reasons, O’Hanlon said. First, many of these companies’ clients also have offices in the suburbs, and companies prefer to be closer to their clients. Also, intown housing prices are typically too expensive for a company’s younger associates.

With overall vacancy rates of more than 27%, Dallas’ CBD is a tenant’s market and likely will remain so for a while. “CBD tenants can expect to see ongoing concessions, and with market equilibrium still several years out, rental rates are expected to remain relatively flat,” Sicola said.

Mobil’s highly publicized decision to relocate its headquarters to Houston, which will add approximately 1 million sq. ft. of vacant space to a Dallas market already out of equilibrium, will create even more of a tenant’s market in the downtown area, Sicola noted.

So, in the final analysis, what are the big draws to downtown these days? A significant amount of available space, the implementation of DART [Dallas Area Rapid Transit] and a new sports arena [the American Airlines Arena] are some of the factors that attract companies, according to Sheryl Pickens, senior vice president in the Dallas office of Chicago-based Transwestern Commercial Services.

Also, Dallas’ downtown compares well on a national level. “Downtown Dallas is the most affordable downtown of any major city in the U.S. as well as one of the most affordable submarkets in the Metroplex,” O’Hanlon said. “It’s the only submarket with viable public transportation to help employees get to work.” Plus, the City of Dallas typically provides economic incentives for major companies that move to the CBD, O’Hanlon added.

Downtown’s biggest problem has been, and continues to be, a lack of residential and retail components to foster a 24-hour environment. “Although its residential base is evolving, there is still a need for supporting retail, particularly grocery and drug store services,” said Sicola. “However, there has been a tremendous focus by local developers and the City of Dallas to enhance the services available to CBD residents and corporations.”

Specifically, Sicola pointed to the construction of the American Airlines Arena, the renovation and expansion of the Dallas Convention Center, and the expansion of the DART light-rail system as adding vitality to the downtown core and producing long-term benefits for the Dallas CBD.

Several older properties in the CBD have been converted into loft condos and hotels. But, “there is not yet enough infrastructure currently in place to meet the promise of work-live-play,” Pickens said. “Due to the aggressive plan in place by the city and downtown property owners, Dallas’ CBD should meet those needs in the near future.”

As for rental rates, the skies are brightening. Class-A rates in downtown range from the high-teens to the low $20s per sq. ft., while rates in Class-A properties in the North Dallas area are in the low- to mid-$20 range, Pickens said.

“Class-A and Class-B buildings in the CBD can definitely compete with the suburbs,” said Greg Biggs, senior managing director in the Dallas office of New York-based Julien J. Studley Inc.

San Francisco gets shaken

The questions first started buzzing right after the infamous April 2000 Nasdaq stock market meltdown. If the tech firms fall, what about all of that nice office space they have been renting or keeping for expansion?

Nowhere were the questions louder than in the heart of techland — San Francisco and the surrounding Bay Area. So how has the tech slowdown really affected the central office market here?

“The dot-com bust has probably had a greater impact on San Francisco than any other market in the country,” said Michael Pitre, corporate managing director in Julien J. Studley’s San Francisco office. “Sublease space continues to flood the market.” San Francisco’s office vacancy rate is around 8%, a three-year high, and rents are approximately $60 per sq. ft. for Class-A office space, Pitre added.

“It has become a tenant’s market, particularly for credit-worthy tenants,” Pitre said. “Good credit tenants can command a 20% discount below asking rates.”

Most importantly, the office market has clearly split between direct space for lease and a whole lot of sublease space. Much of the space for sublease returned to the market when technology tenants in rehabilitated buildings in the South of Market and South Financial District areas folded.

“These will be aggressively marketed with asking rents substantially below what they were just six months ago,” said Jeff Hardy, managing director of the Northern California office of Dallas-based Trammell Crow. “Moreover, they will also come with strong broker incentives to get tenants in the space. This type of sublease space is a harder sell because it is not true office space and is usually located on the fringe of core areas.”

Hardy does not expect the situation to change soon. “As we see more dot-coms fail over the next few months, asking rents for this type of sublease space will drop by about 5% each month and will continue to do so until the market corrects itself,” he said.

However, the San Francisco office market is still very tight, with a 2.5% vacancy rate for direct space, Hardy noted. So the upshot is that a tenant looking for CBD space and not set on a specific location, or type, will find multiple options available. For a traditional tenant looking for Class-A space in the Financial District, it’s still an owner’s market. According to Hardy, these conditions should probably be in place for the next two quarters.

Cushman & Wakefield’s Sicola agrees. “While a large amount of Class-A sublease space has been returned to the CBD market, vacancy in the city’s top buildings remains tight,” she said. “Further stratification of the office market should continue throughout the year as more sublease space becomes available citywide. Although market fundamentals in downtown San Francisco are beginning to shift, a pure tenant market has yet to emerge.”

David J. Churton, senior managing director in Insignia/ESG’s San Francisco office, insisted that downtown San Francisco has been spared the trauma associated with other submarkets. “The greater San Francisco area is ground zero for the retrenchment in the information technology sector that is being discussed in financial capitals around the world,” Churton said. “However, the effects of this retrenchment have been most keenly felt outside the CBD.”

Although average asking rental rates in the financial district have declined approximately 10% to 15% from their all-time high in third-quarter 2000, the crash of the technology sector has had a far greater impact in the South of Market area, where vacancy rates exploded from less than 2% to more than 20% in less than 90 days, Churton noted. Sublease rental rates in the area have declined by as much as 50% from their peaks, he added.

While comparisons to previous years may not show it, all signs continue to point to a burgeoning, healthy downtown office market in 2001 and beyond. “San Francisco is a market in retreat, but it remains the crown jewel of the urban centers in the Bay Area,” Pitre said. “No single industry is driving growth.”

That seems to be the main point: San Francisco is still a whole lot healthier than its neighbors. “While asking rents in San Francisco’s CBD are still anywhere between 15% to 20% higher than comparable space in the East Bay, they are now more attractive than they were just three months ago and remain attractive compared to markets on the Peninsula or in the East Bay,” Hardy said.

“Even though the asking rents in suburban office markets in the East Bay are about $2 per sq. ft. less than rates in San Francisco, given a choice, many tenants would rather be located in San Francisco,” Hardy added.

D.C. burns bright

For various reasons, the Washington, D.C., area is on fire when it comes to commercial office markets. According to Bethesda, Md.-based CoStar Group, the D.C. downtown office market vacancy rate stood at 5.9% at year-end 2000, with some 5.3 million sq. ft. of new space under construction. Net absorption topped a whopping 4.1 million sq. ft. for all of 2000.

“D.C. has an unusually broad base on the demand side, which has historically caused the city’s CBD to outperform other CBDs in slower cycles,” said Louis Christopher, managing director of the Washington, D.C., office of Los Angeles-based Cushman Realty Corp. “Remember, the federal government leases space whether or not the Nasdaq is above 2000. Rents will continue to rise in the CBD in 2001.”

According to Keith Lavey, executive vice president in the Washington, D.C., office of Grubb & Ellis, the market has a strong foundation in the federal government, which will protect the local economy from any big national slowdown.

“Although not immune to the fluctuations experienced in markets such as New York, the security offered by federal spending and employment have, to some extent, protected the District’s office market,” Lavey said. “The federal government contracts with high-tech firms for a variety of services, and helps attract more technology firms to the area, bolstering demand in good and bad times.”

According to a study by George Mason University Professor Stephen Fuller for DC Agenda, a local think tank, the federal government is the largest local customer for technology goods and services in the D.C. area. Its procurement for the region totaled $13.5 billion in 1999, representing 38% of all local technology sales. By comparison, in Silicon Valley, federal procurement totaled just $2.3 billion and accounted for only 4.7% of total sales.

The federal government’s General Services Administration (GSA) is overwhelmingly the single largest tenant in the District of Columbia. According to Lavey, the District contains approximately 97 million sq. ft. of office space, of which the GSA leases 18.5%, or approximately 18 million sq. ft.

According to a recent Grubb & Ellis study, only 15% of the area’s leasing activity was attributable to technology, be it e-commerce, infrastructure or software technology. The remainder was split primarily between the federal government and law firms. For these reasons, Washington’s CBD is not expected to see a dramatic slowdown due to the technological slump.

Cushman & Wakefield’s Sicola agreed. “Although the tech downturn has had the greatest impact on the Northern Virginia suburbs, the downtown D.C. market has remained relatively unaffected,” said Sicola. In fact, initial first-quarter 2001 statistics for the CBD reveal a small decrease in overall vacancy from year-end 2000 to around 2.6%, she added.

Rental rates for direct Class-A space in the CBD are in the $40 to $45 per sq. ft. range, she added. Downtown D.C. features steady rent increases, while the suburban markets often have experienced dramatic hikes, Sicola said.

“D.C. is clearly hot,” said Brett Diamond, senior vice president in the D.C. office of Transwestern Commercial Services. “Any new office construction in the past 12 to 18 months has either been leased or pre-committed, and there is not any major business migration out of the city.”

Another draw is lifestyle. “Washington’s downtown is becoming much more 24/7,” said John Donovan, president of Washington, D.C.-based Carr Real Estate Services. “Now that there is renewed confidence in the city’s solvency, and it has become complemented by more residential and cultural development, its outlook is increasingly bright.”

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