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Suburban Renewal

11/06/2012 | By Michele Lerner

Published May/June 2012

While the days of fields being plowed into office parks may seem like distant memories following the Great Recession, some industry analysts and investors are warming up to the idea that the suburban office market is primed for a slow but steady recovery in the coming months.

The economic slowdown forced layoffs around the country, which, in turn, cut the demand for office space. With more premium office space being freed up, potential tenants used the opportunity to wrestle away concessions from landlords and to move to premier office space in suburban and major central business districts (CBDs).

James B. Connor, senior regional executive vice president for the Midwest region with Duke Realty Corp. (NYSE: DRE), says he sees the tide slowly turning in that regard.

“We think this flight to quality has bottomed out,” Connor said.

Duke Realty isn’t the only company betting that the suburban office market is beginning to make a comeback. At Brandywine Realty Trust (NYSE: BDN), President and CEO Jerry Sweeney says he believes 2012 will be a good year for suburban offices, particularly those in town-center-style properties and locations with strong economic drivers.

Hard Nodes

Of course, there are broad differences between locations and types of properties in terms of how they could rebound from the recession.

Victor Calanog, head of research and economics for Reis Inc., suggests that the end of the Great Recession has yet to translate into appreciable gains for the entire suburban office sector. He points out 70 percent of all office vacancies between 2008 and 2010 were in suburban office properties.

“In 2011, the trend improved a little, with a national office vacancy rate of 17.3 percent,” Calanog says. “But there’s a gap, with a 19 percent vacancy rate in suburban offices and a 14 percent vacancy rate in CBD properties. The recovery has been slower, too. Vacancy rates started falling in CBD offices in 2010, but they didn’t start falling in suburban offices until mid-2011.”

Hans Nordby, managing director for Property and Portfolio Research, a division of CoStar Group Inc., characterizes the premier suburban office markets as a “phenomenal cyclical play.”

“Overall, the CBD office market is healthier than the suburban office market, but there are some premier suburban markets that are doing really well, such as the Rosslyn/Ballston market outside Washington, D.C., and the Route 128 corridor in Boston,” he says. “In the Seattle market, the premier suburban market had a vacancy rate of less than 9 percent at the end of 2011. Tech companies are hot right now, and they tend to be in suburban locations.”

And what makes those regions so attractive
to Nordby?

“Those premium submarkets, which are ‘hard nodes’ – real places in their own right—are potentially the best of both worlds since they are not as aggressively priced as CBD office space and there’s no new supply underway. The result should be good rent growth, good occupancy rates and excellent net operating income (NOI),” he says.

Evolving Demand

Sweeney says he has a vision for what office centers in those hard nodes will look like. He believes the emerging office model will be town-center-style properties that maximize land use and take advantage of  multiple modes of transportation access.

“People want more of a sense of community where they work and they want to walk to retail sites, so the town-center model makes sense,” Sweeney says. “One of our strongest office properties is in Radnor, Penn., which has a 95 percent occupancy rate. This is a prime example of a town-center model, with hotels, retail, 2 million square feet of office space and excellent transportation options, including a regional rail system and several interstates. We intend to deemphasize properties that don’t fit either the CBD location or the town center model.”

Duke Realty Corp. sold more than $1 billion of its suburban office portfolio in seven of its Midwest and Southern markets to The Blackstone Group L.P. in December 2011 as part of its portfolio reallocation. Duke’s long-term strategy is to increase its industrial and health care properties and to refocus its suburban office presence on Class-A properties and strong markets. However, Connor dismisses the idea that the company could be leaving the office sector entirely.

“It’s a misconception that Duke is exiting the office sector,” Connor says. “In fact, we still own $2 billion in office space and another $350 million in office land, all of it purely in suburban locations. We don’t have any CBD office space anywhere in the country for opportunistic reasons.”

Connor says Duke intends to rebalance its portfolio toward a 60 percent allocation to industrial properties, 25 percent to the office sector and 15 percent to health care by the end of 2013.

“One of the biggest changes in the office sector has been the flight to quality from Class-B buildings to Class-A buildings and Class-A to A-plus buildings. The newer Class-A buildings have higher than average occupancy rates, while the older C buildings or functionally obsolete buildings have vacancy rates above 20 or 25 percent.”

Employment and Suburban Offices

The biggest driver of demand for all office space is employment, Sweeney says, so GDP and employment growth would have a positive impact on the suburban office sector as well.

“Our outlook for 2012 is that it will be fairly flat, which is almost directly tied to employment,” Connor says. “Until we consistently see more jobs created, especially on the corporate side, we won’t see a lot of change.”

Yet, even if employment rises, tighter corporate footprints could counteract gains in the entire office sector, according to the analysts.

“Even as companies rehire, most are still off their peak levels, so they don’t need additional space,” Nordby says. “If they had 100 employees and then went to 90 and now have hired two new employees, they still have eight empty desks.”

Calanog says technology also has reduced demand for space, since most people can work anywhere. According to Calanog, the average square feet per employee today is 90, while in the 1990s, the average office allocation was 150 to 200 square feet per employee.

However, according to Connor, even though corporations are under pressure to make do with less space, it isn’t always easy to reconfigure an office, especially for companies with 25,000 square feet or less to work with.

“It’s a misconception that you can now put 25 people in a space that held 20 employees,” Connor says. “Really, only large tenants with 100,000 square feet or more can reengineer their space to get that much more efficiency.”

Companies that lease new space in both CBD and suburban properties are shifting their use to smaller work stations, Connor notes.

“All major users are placing greater emphasis on communication, so instead of a lot of large private space, companies prefer to have meeting space and open areas for people to gather,” he says.

As the economy improves, Nordby expects to see more demand for better and larger office space in CBDs and in premier suburban locations.

“Corporations focus on the most efficient use of space when they have an oversupply of employees, but when you can’t find good employees, then you start to look into offering offices with more square feet and more amenities,” Nordby says.

Local Economies Key

So which suburban areas are likely to come
back quickest?

“REITs that are invested in better suburban markets should do above average in the long term,” Nordby says. “Premier suburban markets with higher value-added activities often perform as well as the CBD in those same cities, and sometimes better. For example, suburban Seattle office activity is driven by the tech industry and suburban Houston is driven by the energy industry, and the premier suburban submarkets are doing very well in those metros.”

Brandywine’s overall office occupancy rate is 87 percent, but there are broad differences in performance from one region to another. In Austin, Texas, for example, Brandywine has a 98 percent occupancy rate and significant rental increases because of the lack of supply and diversified economy.

While demand for suburban office space depends a lot on location, Calanog points out that there is virtually no development of office space in the pipeline today.

“How companies look at office space is changing, and on one level, this will mute the demand, but there’s a corollary impact of supply,” Sweeney says. “There will be a significant lag time before new development can occur, so rental rates will move up as the economic situation clarifies.”

Slow Growth Likely

Overall, while no one is calling for an immediate boom in the suburban office sector, some analysts do expect to see a gradual improvement, particularly in desirable locations with diversified employers. Calanog says he expects vacancy rates to decline slowly over the next year or two, accompanied by a slow but steady overall recovery, including positive rent growth.

“The recovery in the suburban office sector will continue to be very gradual in 2012, because there’s no big movement in the overall economy,” says Connor. “We’re consistently seeing tenants that need more space, but are not quite confident yet to make a move.”

Nordby says that the suburban office sector must be analyzed separately in premier and non-premier markets. He believes less desirable assets will struggle as properties in premier markets improve.

Sweeney points out that office space is always a lagging indicator, but he says Brandywine is expecting 2012 to be a good year.

“We are cautiously optimistic about continued improvements to the economy and we expect to approach 90 percent occupancy by the end of 2012 and have positive same store growth,” Sweeney says. “Our challenge is controlling capital costs and optimizing effective rents in this transitional economic period.”

 

 

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Michele Lerner is a regular contributor to REIT magazine.

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