Has the downtown real estate market reached its peak?

By JOHN BLISS
Unico Properties

The downtown Seattle and Bellevue office markets are consistently touted as two of the most attractive investment markets nationwide. The proof is easy to spot. Vacancy is well below five percent. Rents have risen 25 percent in the last 12 to 18 months. Tenant improvements and other lease costs have fallen dramatically.

The first signs of these trends were visible in late 1995 and led to an unprecedented round of office building trades starting in late 1995 and ending abruptly in 1996. Almost as a rule, these trades were at about 60 percent of replacement cost and at cap rates of around eight percent, due to existing rents well below market.

With the exception of San Francisco-based William Wilson & Associate's purchase of 110 Atrium Place in early 1997, there were no major trades of downtown buildings until late 1997. A flurry of office transactions at the end of 1997 pushed market values much closer to today's replacement cost. Three transactions are significant.

• US Bank Center/Plaza Center, a 455,000-square-foot office complex in downtown Bellevue, was purchased by Speiker Properties in a hotly contested bid process. The price of nearly $180 per square foot for late 1970s/early 1980s vintage buildings set a new high watermark for acquisition price relative to replacement cost.

• The prized Wright Runstad portfolio was purchased by Sam Zell's REIT, Equity Office Properties. The portfolio includes six large local buildings: (in Seattle) Second & Seneca, 1111 Third Avenue, Nordstrom Medical Tower and the First Interstate/Wells Fargo Center; and (in Bellevue) Rainier Plaza and One Bellevue Center.

  Due to the deal structure, it is difficult to ascertain precisely where the portfolio traded relative to the common cap rate and price per square foot measures. It is safe to bet, however, that the value attributed to the class A high rise properties in Seattle and Bellevue was in excess of $175 per square foot.

• Most recently, and clearly of most significance, US Bank Centre, a 930,000-square-foot tower considered one of the West Coast's premium office buildings, was sold to Bentall Corp. for $240 million, or nearly $260 per square foot. This sale, negotiated without a wide bid process, captured the biggest price for an arm's-length transaction that Seattle has seen and certainly pushed the envelope farther in terms of low going-in yields.

Rent increases will spark new office development, but don't look for the million square foot highrises of the 1980s. Projects will be more modest, such as Trammell Crow's proposed 300,000-square-foot office building, a co-development with the Washington State Convention and Trade Center. Courtesey of Callison Architecture.

As Seattle's commercial real estate market has continued to feast on the market upswing since the mid-1990s, many ponder how long the good times will last before the market passes the peak and encounters a real or perceived downturn. Will the recent activity, particularly the sale of US Bank Centre in downtown Seattle, spur a round of sales similar to 1996? To answer this question, focus on two barometers of the market.

Comparable West Coast markets

The office market watchers who see both the downtown Seattle and San Francisco markets, commonly conclude that Seattle has loads of room left for rent growth as evidenced by San Francisco rents approaching and in some cases cresting $50 per square foot.

Although this conclusion may have some degree of accuracy, the wide rent differential points to just how extraordinary the US Bank Centre deal was. Even with San Francisco's high level of market rents, perceived opportunity to dramatically grow rents, more severe supply constraints and greater replacement costs, San Francisco's office trades have generally been in the plus or minus $200 per square foot range. (The pending exception will be the irreplaceable Embarcadero Center, which is expected to be priced well above $300 per square foot.)

The situation is similar in the strong West Los Angeles market where trades, with the exception of Fox Plaza, have not approached the $260 per square foot commanded by the US Bank Centre.

The gist of these market comparisons is that Seattle and Bellevue market values are already strong relative to our West Coast peers. As current below-market rents in downtown Seattle and Bellevue buildings rise to market, the cap rates will also rise slightly to govern the per square foot prices.

New supply?

The strong demand and limited supply for office space in Seattle and Bellevue that has been driving rent escalations is also increasing the likelihood of new office building construction. Although it is safe to assume that a number of the announced or proposed new office projects will not get off the ground in the near future, it is evident that today's new rent economics will support at least a modest amount of new office development.

This is already evident in projects which are largely pre-leased and are not bogged down with unusually high carry or other predevelopment costs, such as the Visio Corp. portion of the Port of Seattle/Wright Runstad World Trade Center project.

Rents are also reaching the level to support smaller multi-tenant, speculative projects which can be delivered at a reasonable cost.

A prime example is Trammell Crow's proposed development, One Convention Place. At 300,000 square feet, this is a modest-sized office building relative to the typical one million square foot projects of the late 1980s. It reportedly will cost less than $225 per square foot to build, a cost which can arguably be supported by today's rents and a minimum level of optimism on the lender's part.

This necessary ingredient of rent growth optimism by the lenders, however, will disappear if it starts to appear as if a large number of new projects will get built within the next two to four years.

More transactions?

What does this mean to the values of Seattle and Bellevue buildings today? Our reading of the tea leaves says it means that the steepest part of the "gain in value" curve is behind us and that future increases in the value of existing properties will be more modest.

The significant number of development projects proposed, coupled with the economic viability of at least a few projects, may spur those owners already predisposed to selling to recognize that their biggest gains may have already occurred.

We believe that the target set by the US Bank Centre trade and the likelihood of at least some new supply will lead to three to four major sales transactions in downtown Seattle, and possibly, Bellevue in the next 12 to 18 months.

Copyright © 1998 Seattle Daily Journal of Commerce.